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The sub-lessor airline: the market responds
Author: Philip Perrotta - Partner, Clyde & Co
Date: January 2009

The last few months have seen the emergence of an increasingly popular trend in the aircraft leasing industry: the sub-lessor airline (SLA). In the current climate of a global economic downturn and consumers beginning to tighten their belts, some airlines are finding that revenues are down, cash flow problems are up and their operating fleet size needs to be trimmed in order to meet the corresponding decline in passenger numbers. In order to release capacity, remain competitive and boost income in the short to medium term, more airlines are opting to sublease their aircraft and are therefore finding themselves in the shoes of a sub-lessor.

In contrast to the profile of an owner-lessor, an SLA is less likely to be cash rich and will often carry an associated higher insolvency risk. Indeed, an SLA's decision to sublease may itself be seen by some prospective sub-lessees as an indication that insolvency is in prospect, or at the very least that the SLA is responding to the risk of its future financial uncertainty and instability. Prospective sub-lessees are rightly concerned that the heightened risk of an SLA's insolvency will adversely impact the quality of the comfort derived from the usual lessor covenant of uninterrupted use and quiet enjoyment of the aircraft.

The fact of some owner-lessors having over-ordered new aircraft, coupled with fewer lessees to meet those orders, means that the increasing number of airlines opting to sublease their aircraft has begun to shift the balance of supply and demand in the aircraft leasing market to the lessee's favour. This shift has had the effect of significantly improving the prospective sub-lessee's commercial bargaining position when negotiating the terms of the sublease with an SLA. Moreover, the corresponding increased risk of leasing from an SLA has meant that lawyers acting for the sub-lessee are in a much stronger position to introduce devices and negotiate provisions to afford the sub-lessee protection against, and mitigate the effects of, such risks.

Of particular concern to an airline is its ability to maintain a level of certainty and control over its fleet size, specifically for route and capacity planning requirements. In the case of a lease from an SLA, any insolvency of or even indebtedness under any other agreement (under a cross-default provision) by the SLA could lead to the termination of the headlease, and therefore the termination of the subordinated sub-lease, thus leaving the sub-lessee without the requisite use and quiet enjoyment of the aircraft.

"Cut-through" to owner

To guard against such risks, one device which some lawyers have successfully negotiated for prospective sub-lessees is an option for the sub-lessee to continue leasing the aircraft directly from the owner in the event of a head lease termination. The general terms of such an arrangement could be (and often are) contained in the owner quiet enjoyment letter, or in some other agreement entered into directly between the owner and sub-lessee. A common problem with this approach, however, is that the owner may not be happy to continue leasing to the sub-lessee on the same terms negotiated between the SLA and the sub-lessee, particularly if the sublease contains other (sub-lessee friendly) provisions as a result of the SLA's weaker bargaining position as a non-owner and lessee of the aircraft itself. This issue emphasises a broader (but still emerging) trend: the divergence between what is becoming "market standard" in an SLA operating sublease, as compared to the more familiar owner operating lease market standard.

Protection for security deposit

Another common concern when leasing aircraft from an SLA is the return of the security deposit on termination of the sublease in the event of the SLA's insolvency. A claim against a UK (incorporated) SLA in administration for the return of security which has been comming led with the airline's other funds will give rise only to an unsecured claim (prorated against other unsecured creditors) on any monies remaining after secured and preferred creditors have been paid. Of course, any prospective lessor will want a security deposit paid in cash, with an unfettered ability to commingle the proceeds with other funds and apply the proceeds to whatever purpose and in whatever manner it chooses. However, some sub-lessees have been successful in negotiating with SLAs better protection for the payment of any security, with respect to both its amount and form.

The most effective way the sub-lessee can seek to protect its security deposit is to insist the funds are deposited in an account belonging to a third party to hold in trust for both the SLA and the sub-lessee. The security is accordingly held separately from the SLA's own bank accounts, and therefore outside the reach of both the SLA and any potential insolvency practitioner.If the SLA is not amenable to such an arrangement, other forms of protection, such as the following, could be negotiated by way of compromise:

• the deposit could be held in a separate dedicated bank account owned by the sub-lessee but charged in favour of the SLA;
• the sub-lessee could offer to arrange for a letter of credit to be issued in favour of the SLA as an alternative; or
• as a last resort, the sub-lessee might try to ensure that the deposit is not commingled with the SLA's other funds, and therefore kept in a separate dedicated account owned by the SLA.

Maintenance reserves

Similarly, all maintenance reserves paid in relation to the aircraft could be protected using similar devices. However, as maintenance reserves are ultimately for the benefit of the owner of the aircraft, and not the SLA, it might be possible to agree that the maintenance reserves are paid directly to and held by the owner.

Redelivery provisions

Lawyers acting for a sub-lessee may also want to protect their clients against an SLA abusing the redelivery provisions of the sublease, through the introduction of technical adjudicator language. Without such language, there is potential for an SLA to refuse to accept redelivery on unsubstantiated grounds, and profit during the resulting period of dispute. It may be desirable for the SLA either to extend the effective lease period to plug a 'leasing gap', or to profit from punitive monthly rentals during such period.

"Net lease" provision

Another provision of the sublease that the sub-lessee may seek to protect itself against, in relation to an SLA, is the 'absolute obligations' payment clause (sometimes called the 'net lease' or 'hell and high water' provision), which normally provides that the sub-lessee's rent payment obligations are absolute, unconditional and non-refundable irrespective of any circumstance. The sub-lessee might insist that this provision remains effective only to the extent the SLA remains solvent. In other words, such qualification would potentially allow the sub-lessee to pay rent in arrears in the event of SLA insolvency, avoiding a scenario where the sub-lessee would have to reclaim a portion of a month's rent (as an unsecured creditor) if it has received the benefit of only a few days use and enjoyment of the aircraft before the sublease is terminated (due to SLA insolvency).

Lessor events of default

A further device which is becoming less uncommon is the introduction of lessor events of default. Typically, such events (which are likely to include lessor insolvency) will afford the sub-lessee the option to terminate the lease. Having the option to terminate is generally attractive for greater flexibility but may also be a great relief to sub-lessees who are concerned that the SLA may be unable to honour its obligations, compromising their use of the aircraft.

Other matters

Finally, the sub-lessee may also capitalise on its improved bargaining position by negotiating, amongst other things, more lessee friendly condition precedent provisions, less onerous representations and warranties, and fewer and more favourable (lessee) events of default.

Conclusion

In the past, such mitigative provisions may have been regarded as a significant divergence away from what was generally considered to be the "standard operating lease". However, the changing climate of the global economy means that there is no longer a "standard operating lease" per se, and that every leasing arrangement should be considered in its own right, free from preconceived ideas. A prudent airline should ensure that it is proactive, and not reactive, when guarding against the increased risks associated with the current market conditions.