Raising finance

Julia Salt and Ben Conway give the lowdown on methods of commercial aviation funding

Aviation finance is the generic term used for activities relating to the business of providing funding for participants in the commercial aviation arena. This funding can be supplied through a variety of structures, all with the aim of providing financing solutions to those who own and lease aircraft and to the airlines.

Operating leasing

Under the typical scenario, the lessor enters into an agreement with the lessee for a definite period of time. This is subject to earlier termination on default and sometimes has extension options. During this period, the lessee has the exclusive right to possession of the aircraft in return for payment.

Finance leasing

The lessee, as opposed to the lessor, takes the risks and rewards of ownership in that the payments by the lessee during the lease term, including any final balloon payment, will be sufficient to cover the lessor’s investment in the aircraft, plus a return. The title passes to the lessee at lease expiry, or, if there are tax disadvantages in this, a sale proceeds.

Syndicated lending

Given the high cost of a new aircraft, a syndicate of banks rather than one bank is customarily used to spread each financier’s risk. A security trustee usually holds the security, which is invariably a mortgage, on behalf of the other financiers. Syndicated loans are arranged direct to airline operators, or sometimes to finance or operating lessors.

Export Credit Agency-supported funding

This is provided by a number of countries (principally the US, the UK, France and Germany) to encourage exports of aircraft and engines manufactured in these countries. There are certain restrictions relating to the ultimate operator of an aircraft financed using this method, but for those able to take advantage it provides access to good funding rates given the guarantee provided to the commercial financiers. It will be combined with the other structures above.

Principal market restrictions

One of the most important considerations for any person providing finance for the acquisition or refinancing of an aircraft relates to the provision of security. An aircraft as a moveable asset clearly presents certain challenges not inherent in a financing secured by real estate, for example. The financier has to be satisfied that the form of security taken will not only be recognised by the laws of the country where the aircraft is registered but will also prove effective in obtaining a quick enforcement against the aircraft in case of default by the operator.

Recognition of the creditor’s rights on the insolvency of the operator are also important, particularly where the rating given to the securitisation vehicle is partly dependent on the ease of enforcement and repossession of the aircraft. At present, the position relating to the effectiveness of security over an aircraft is fragmented, with the courts of a country applying their own national rules relating to validity and enforceability of the security interest. The court may look to the lex situs (the location of the aircraft at the time of mortgage creation), the law of the state of registration of the aircraft, or another basis. Traditional common law jurisdictions generally recognise a mortgage over an aircraft and provide predictable enforcement mechanisms. This can be contrasted with a civil law approach that may not be so receptive to self-help remedies.

The pool of available financing from such sources as insurance companies has the potential to increase in response to the greater demand for financing for new aircraft, given the predicted increase in air travel and the retirement of certain aircraft types after new requirements on noise emissions for example. There may consequently be a benefit from establishing a clear internationally-based system of mutual recognition of interests in aircraft.

What attempts are being made to address concerns?

The Convention on International Interests in Mobile Equipment and the associated protocol to the convention on ‘Matters Specific to Aircraft Equipment’ was signed in Cape Town on 16 November 2001. It attempts to address key concerns of financiers and lessors, with the aim of establishing international protection for interests in aircraft – including the ownership interest of a lessor; providing the holders of those interests with a range of default remedies; providing for a register by which to perfect those interests and give third parties notice of them; and setting out a priority system for competing international interests. The convention and protocol (together the Cape Town Convention) are not yet in force because the required number of countries have not yet ratified.

The central tenet of the Cape Town Convention is the creation of the concept of an ‘international interest’ – an interest in relation to airframes, engines and helicopters granted under a security agreement, a conditional sale or a lease complying with the prescribed formal requirements of the convention.

The Cape Town Convention applies when, at the time of the agreement creating the international interest, either the debtor is situated in a contracting state or the airframe or helicopter is registered on the aircraft register of a contracting state. The holder of the international interest may, on the occurrence of a default, exercise certain remedies, including taking possession of the charged object. However, the effectiveness of these remedies may be tempered somewhat as at the time of ratification, a contracting state might require that such remedies can only be exercised in its territory pursuant to a court order. The customary practice of obtaining deregistration powers of attorney from the operator is given teeth as the holder of the international interest gains entitlement to procure deregistration provided the operator has agreed at any time.

Notice to third parties of the existence of an international interest is achieved through a registration system that provides for priority of a registered interest over unregistered and later registered interests. The protocol contains two alternative insolvency rules intended to facilitate enforcement and provide certain time periods. However, a contracting state is only bound by these provisions if it so elects at the time of ratification and consequently, their effectiveness is somewhat impaired.

Overall, the Cape Town Convention, if and when ratified by a sufficient number of states, should have a positive impact on funding, given the greater certainty that an interest will be recognised in a contracting state. However, local courts are still likely to have a major role to play in enforcement and, given the non-mandatory nature of the insolvency regime, concerns will remain.

UK insolvency changes

When the Enterprise Act 2002 is fully introduced, which is expected to be in June 2003, it will have a fundamental impact on UK security law, but perhaps a more limited impact on aviation financing.

When introduced, the appointment of an administrator as opposed to an administrative receiver will become the primary means of enforcing security. An administrator’s main objective will be to rescue the company. The right to appoint an administrative receiver apart from in certain specified matters will be abolished and companies and directors, in addition to secured creditors holding a qualifying floating charge, will be permitted to appoint administrators using a new out-of-court route.

There are provisions in the act – such as the proceeds of sale flowing from a court ordered sale of the aircraft being available to the fixed charge without deductions for the expenses of the administration – which will make a floating charge less attractive than a fixed charge and provide an advantage to fixed asset lenders. Given the diverse range of financiers with security over different aircraft in an airline’s fleet, the appointment of an administrative receiver over all of the assets by one secured lender under the existing regime and use of the floating charge, is not as prevalent as in some other lending areas.

Julia Salt is a partner and Ben Conway is an associate in Allen & Overy‘s asset finance group