Lean, green flying machines: Aviation and CORSIA leading the way?

We are observing a distinct uptick in press coverage of aviation in the context of climate change discussions of various kinds at the moment. The headline item is, of course, the conversation about the proposed place of aviation within the Green New Deal plans in the United States, and what that might look like in the context of a 100 per cent carbon-neutral society, alongside clean fuels, high-speed electric rail, etc. At the industry level the conversation is centred on the new Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), as the mandatory emissions reporting requirement kicked in on 1 January this year.

Closer to home, we are also seeing incoming lessees, lessors and financiers asking these questions when re-leasing aircraft emerging from the various recent airline insolvencies, as people query the ongoing place of the familiar EU ETS letter and seek to understand where the new CORSIA reporting requirements will need to be accommodated in lease and finance documentation, and how this monitoring will be carried out and reported in practice. The freshly updated Green Loan Principles are also raising questions in asset finance generally, as the latest advice in relation to how these principles can be applied to revolving credit facilities clarifies the options available to operators and financiers in terms of green tranches within working capital revolvers.

What seems clear from all of these discussions is that the finance aspect of the industry will be equal in importance to technological advancement if aviation is to meet the targets and regulatory regimes to which it has signed up, within the necessary time frame.

CORSIA takes a two-pronged approach to ensuring that airlines are able to cap their emissions at 2020 levels, by imposing the reporting requirements mentioned above to encourage emissions reductions in the first instance by way of transparency, but also by establishing an offsetting scheme requiring carriers to buy carbon credits from other industries that have made more progress in their reductions, thereby financing advances in other fields while aviation technology catches up. As a result, it may be the case that we see airlines seeking to use green loans or green revolver tranches to finance the purchasing of these credits, which will encourage the development and meaningful implementation of emissions reductions technologies in various industries as well as in aviation, while simultaneously making investment in aviation more attractive to financiers keen to show participation (and tangible results) in green financing.

Intriguingly, it has been suggested that CORSIA might be a source of hope to industry generally, as an example of the ways in which the ‘profit incentive’ can be mobilised for environmental good. “In short,” it has been observed, “CORSIA could catalyse a global carbon market that drives investment in low-carbon fuels and technologies” (Less Than Zero). Aviation has a real opportunity to show leadership on this issue, despite the distance yet to be covered in terms of more efficient equipment and less harmful fuel sources. And with the next generation of aviation CEOs (now as young as 10 years old and already proving to be both observant and organised: Qantas boss Alan Joyce responds to letter from 10yo CEO of Oceania Express) watching us closely, the example we set and the changes we make now will be beyond price.

(Un)Happy Valentine’s Day

It turned out to be an unhappy Valentine’s Day for the Airbus A380 and her admirers, as Airbus announced the scrapping of the A380 programme, with the last deliveries scheduled for 2021.

It’s hardly a shock, however, after the fleet’s first retirement last year and with two of them already being parted out. The economics of operating these fantastic beasts just never really made sense, however game-changing the concept (or indeed the passenger experience).

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How many racehorses can you fit inside a 747? – Dublin Conference Week 2019

The answer to this question is just one of the many fascinating things the Reed Smith aviation finance team discussed around St Stephen’s Green this January, as members of our London, Paris and Miami teams attended aviation’s largest annual industry gathering in Dublin.

The presiding concern in discussions this year was where the industry is in its cycle. More and more money is being made available, by banks and private equity, to the point where we are now hearing that there is more money than there are aircraft to back it. We have heard, for example, of nascent leasing platforms that are fully funded but are struggling to obtain the necessary aircraft, and of end-of-life lessors/operators and cargo carriers having to take retired aircraft back out of the desert and refit them, due to the disruption caused by the necessity of keeping mid-life aircraft in service to meet capacity demands, to cover manufacturer delays affecting new aircraft and to provide assets capable of delivering the yields required by this influx of funding.

While the abundance of cash is causing certain stresses on the aircraft life cycle and pressure on margins, conference week also made it clear that this cash and those responsible for deploying it are increasingly asset-agnostic, drawn by the prospect of high single- to double-digit returns and long asset life rather than by the assets themselves. These investors tend to be already active in shipping, rail, real estate and even aerospace as they look for new opportunities in aviation. We spoke to people mandated to invest anything from US$2 to 8 billion in the industry over the next 24 months, so it seems there is quite the investment pipeline developing, with all of the attendant challenges and opportunities (and warning signs). However, it is not just about investing in ‘aviation’ across the board, but rather about finding the right airline, aircraft and region at the right time.

This combination of ready funds and potentially scarce metal, when considered in light of more macro factors relating to jurisdiction (for example, the as-yet-untested new economic substance rules in the Cayman Islands, ‘trade war’ issues, and general Brexit uncertainty), would seem to suggest that we will increasingly be seeing more asset trades rather than M&A activity, as it becomes more efficient and less risky to buy and sell the assets themselves rather than the entities or platforms that own them. (This tends to be the preferred approach in aviation, as size is not necessary for survival and M&A tends to be seller-driven – for example, in distressed situations.) This would, in some cases, include the financing arrangements attached to the asset, so that secondary debt trading may in tandem become more of a focus. The sale and leaseback market is also likely to continue apace as competition to finance and own the aircraft intensifies, with lease extensions and novations similarly continuing to tick over as operators try to hold onto or redistribute the capacity they already have.

It therefore seems that we are in for an interesting year, as new players come to prominence, financier attention shifts and grows, and we collectively deal with regional economic and political turbulence. Overall, we would say the atmosphere at the conference was wary but optimistic, and there was a general enthusiasm to tackle these emerging headwinds, as well as real enthusiasm from the financiers to get stuck in.

The answer, in case you are still wondering, is 67.

Elusive, yet still alluring: What did 2018 show us about investment in aviation?

At the end of last year I wrote a published piece entitled “The Allure of Investing in Aviation”. A client asked me this week whether, a year later, I stood by what I’d written.

To answer that, you have to decide whether or not you think 2018 was a good year for the airline industry as a whole. There were many highs, but some telling lows as well. There can be no doubt that we are still in a ‘supercycle’ of sorts, but this has to be balanced against both macro and sectoral environmental conditions.

The expectations as we headed into 2018 were that profitability would improve over the year, with 56 per cent of airline CEOs in a positive mood[1]. However, this positivity has to be tempered by IATA’s adjustment of its own profit forecast from US$38.4 billion in December 2017 down to US$33.8 billion by June last year[2].

So what should investors be looking at? Is aviation still an attractive investment?

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So long, farewell … and happy new year! 2018 trends and 2019 opportunities

Our aviation finance team has made it to the end of its first complete year since its relaunch in summer 2017 – and it has been a big one! We have worked on transactions involving over 100 aircraft and 19 different jurisdictions, we have met with clients and friends in Dublin, New York, Hong Kong and London, and we have seen our renewed team go from strength to strength as we welcomed new members in Paris and the United States.

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New Sikkelee decision from the U.S. Court of Appeals for the Third Circuit – state law claims against type certificate holders are not conflict preempted

In a very significant, closely watched aviation product liability preemption case in the U.S. Court of Appeals for the Third Circuit, Sikkelee v. Precision Airmotive Corp., et al., No. 17-3006, 2018 WL 5289702 (3d Cir. Oct. 25, 2018), the court recently held that state law claims against type certificate holders can go forward unless the defendant can show that the FAA would not have approved a plaintiff’s proposed change to the FAA type certificate. The court held that the plaintiff’s design defect claims against Lycoming, the type certificate holder for the engine on the accident aircraft, were not conflict preempted because Lycoming was in a position to make changes to its type certificate and was unable to show that the FAA would not have approved the alternative engine design the plaintiff proposed. The court emphasized that allowing state law claims to proceed against type certificate holders complemented the federal scheme and furthers its purpose of ensuring the safety of aircraft. Accordingly, under this ruling, it appears that the only time a type certificate holder can potentially succeed with a conflict preemption defense under these circumstances is if there is clear evidence establishing that the FAA would not have approved an alternative design proposed by the plaintiff.

The dissent held that the claims were preempted and pointed out significant issues with the majority’s decision. The majority relied primarily on a U.S. Supreme Court case which held that state law claims against brand name pharmaceutical manufacturers are not preempted because the manufacturer was able to implement changes prior to receiving FDA approval. The dissent pointed out the critical distinction between that case and Lycoming – unlike a brand name pharmaceutical manufacturer, an FAA type certificate holder cannot implement design changes without prior FAA approval. Thus, the dissent held that the majority’s analysis was flawed because it would be impossible for Lycoming to independently implement the changes that the plaintiff alleged state law required. Continue Reading

Aviation Finance: The Hong Kong Report

The Hong Kong conferences are over for another year, and our Aviation Finance team had another very productive week at the various sessions. It was great to see so many familiar faces and connect with new people, and doing so in what is fast becoming one of the world’s new aviation finance powerhouse jurisdictions gave the meetings a real buzz.

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Fuelling aviation: What would Iron Man do?

Aviation seems to be facing a fuel-related existential crisis at the moment, as pressures mount on the industry from various angles.

Within asset finance generally the major discussion is the looming bite of the IMO 2020 regulations, which will reduce the amount of sulphur permitted in ship fuel oil to a limit of 0.50 per cent mass by mass from 1 January 2020. Aside from the huge impact this will have on the world’s vessel owners and operators, it is also anticipated that there will be knock-on effects for aviation.

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An Introduction to ECA Finance

In this blog post we take a brief look at export credit agency (“ECA”) supported finance in the asset finance industry, and the development of a new template loan agreement by the UK’s Loan Market Association.

The role of the ECAs

 ECA finance describes transactions where states (whether by direct sovereign bodies or by separately mandated organisations) provide (financial) support to would-be purchasers of certain goods or equipment constructed in that ECA’s home jurisdiction.

ECA support can make deals both more bankable and more affordable, and has long been a useful feature of asset and project finance. Over the last two decades, a significant amount of export credit support in the form of both guarantees and insurance has been provided to capital-intensive global projects.

With the increased capital adequacy requirements of the Basel III and Basel IV accords, the importance of the sector has continued to grow. ECAs were once seen as insurers of “last resort” and were largely confined to support high risk financings in emerging markets, with much export credit agency insurance having been counter-cyclical. Whilst the perception remains that ECA support increases in importance as traditional financiers become more reluctant to lend (and so provides a bridge where the required debt finance exceeds the available bank liquidity) they just as often will now be found providing specialised products not available elsewhere, for example political risk insurance.

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Flypasts, Flybraries, Hurricanes and Paper Planes: The Summer Reading Edition

The heatwave may be over but the wave of August out-of-office responses is still building, so rather than post about controversial redelivery conditions or the fascinating behaviour of interest rates, and prompted by the striking intersection of aviation and literature recently, we thought it seemed high time to offer Legal Flight Deck: The Summer Reading Edition. You’re welcome.

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Farnborough International Airshow 2018: Notes from the runway

The Reed Smith Aviation team were out in force for FIA 2018. It’s always nice to be able to catch up with clients and old industry friends from across the globe on our own doorstep – and even better when it’s in the middle of a heatwave!

New orders

Boeing’s executives are likely to be flying back to Seattle feeling very pleased with the week’s work, having secured/announced $79 billion in orders during the show. Vietjet signed an MoU for an additional 100 Boeing 737 Max aircraft and Hawaiian Airlines also confirmed its order for 10 787-9s, while also confirming purchase rights for an additional 10 aircraft. Overall Airbus announced 93 firm orders and commitments for 338 aircraft, including a commitment from JetBlue for 120 of its new A220 aircraft and a confirmation from AirAsia X for 34 A330neos. Embraer had a much more successful show than last year, securing/announcing 265 orders for variants of its EJets.

There was plenty of lessor activity to note across the week with Goshawk Aviation (20 Boeing 737 Max 8 aircraft) making its first direct order from Boeing and Jackson Square Aviation (30 Max-family aircraft) making its first direct purchase from any OEM. Macquarie AirFinance ordered 20 A320neos and ACG ordered a further 20 Boeing 737 Max, taking its current order to 100. Continue Reading

When will a lease agreement be void for common mistake?

Summary

In last week’s case of Triple 7 MSN 27251 Ltd v. Azman Air Services Ltd,[1] Azman Air Services argued that two aircraft lease agreements were void under the English law doctrine of common mistake.

The High Court considered this question and found that common mistake is only sufficient to void a lease agreement (or any other contract) where:

  1. the mistaken assumption on which the parties acted was fundamental to the contract; and
  2. the mistake was such that the “contract or its performance would be essentially and radically different from what the parties believed to be the case at the time of the conclusion of the contract”.

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The changing of the guard: Millennial asset finance

According to PWC research, half of the world’s workforce will be millennials (people born between 1980 and 1995) by 2020. It is also estimated that over the course of the ‘Great Wealth Transfer’ occurring over the coming 30 years, this generation will inherit wealth to the value of $30 trillion.

A lot of editorial ink has been spent on the analysis of millennials, especially on the ways in which their spending habits differ from those of previous generations (smashed avocado, anyone?). It has been reported that the particular context in which this cohort grew up – described by one columnist as ‘a series of moments when the big institutions failed to provide basic security, competence and accountability’ – has ‘fundamentally changed the game for Millennials’. They don’t buy houses in the way their predecessors did. They want access to cars, but not necessarily to own them, and would rather have a smartphone anyway. They are characterised by a ‘quirky eco-conscious individualism’. They want workplaces that offer flexible hours and feel like a community, and would rather keep their lives than work towards partnerships or corner offices.

Similarly, in recent months, we have seen a marked generational change in some of the lenders we work with. While some are determined to carry on as if the GFC never happened, others are looking at building brand new books with innovation and new technology at their core, even in more traditional fields like asset and equipment finance.

All of this has made us wonder. If millennial spending habits are so different from those of previous generations, why should their lending habits stay the same? What happens when the millennials are running those ‘big institutions’? Specifically, what will millennial asset finance look like? Continue Reading

Turboprops are back – and better than ever

The green button has been pressed – airlines are placing orders for turboprop aircraft at top speed. With high velocity, low thrust and the exciting potential of 3D printing, will turboprops make their return to the “hot spot”? In the constant search for efficiency and ways to generate revenue, there are many advantages to this kind of aircraft and more in store as new technologies highlight the possibilities – some of which are already being realised in projects like China’s ‘Belt and Road’ initiatives and the development of emerging aviation markets.

The turboprop profile is definitely on the rise. With a $332 million order for Q400s placed  this week by Ethiopian Airlines, for example, following China’s delivery of 57 MA series aircraft throughout 2017 to New Silk Road regions, and with manufacturers like Rolls-Royce and GE Aviation increasing competitive development in the field, it is fair to say that the turboprop market is experiencing a resurgence of interest.      Continue Reading

Wanted: Blue sky solution to big green problem

The aviation industry is a major contributor to the world’s carbon emission and greenhouse gas problem, generating 2% of the world’s carbon dioxide emissions and estimated to account for 3% by 2050. The UK’s aviation sector, for example, was responsible for 34 million tonnes of CO2 emissions in 2012, a figure forecast to rise to 43.5 million tonnes by 2030 [1].

The huge volume of commercial aviation activity, the long distances we now travel, the massive amount of fuel burned to power the equipment, the release of emissions directly into higher levels of the atmosphere, the ever-growing demand for capacity – this all adds up to a very knotty problem for the industry to address. How can we better balance the need to accommodate unprecedented growth in demand with the environmental imperative to fly far less than we already do?

There are a number of methods currently in use, of varying levels of effectiveness. Continue Reading

Little Miss Pilot: Where next for aviation’s gender pay gap?

More data on aviation’s gender pay gap has become available since our first post on this in January, and a theme has emerged across the more prominent pay gap reports.

This is that although men and women may be paid equally for doing the same job, the figures are significantly affected by the fact that the vast – the very vast – majority of senior and therefore more highly paid jobs are held by men. In most cases, in aviation, this means pilots. We saw in the EasyJet report that just 86 of their 1493 pilots were female; at British Airways the figure is 94% male, at Jet2 it is 95%, and 95% again at Tui Airways. The BA report helpfully notes what their figures would look like if pilots were removed from the equation – there would be a 1% gap, in favour of women. It is clear where the problem is.

So how do we fix it? We have seen countless commitments to ‘close the gap’ and declarations of equal opportunity and gender-blind recruiting, but what does doing something about it actually look like? It may be, after all, that recruitment policies and retention initiatives are not the source of the problem. It may be that it begins much earlier than that. Continue Reading

Too hot to handle? The perils of the super-heated sale and leaseback market

The sale and leaseback (“SLB”) model has been a key source of funding and portfolio management for lessors and airlines alike for some time now.

There are two principal SLB transaction structures employed for new aircraft, as illustrated below.

The first is the “back to back” sale, whereby an airline pays for and takes delivery of an aircraft as the purchaser under the purchase agreement with the manufacturer. The airline will then simultaneously sell the aircraft to the lessor and takes it back on lease. The second is the “purchase agreement assignment” variant, in which the purchase agreement with the manufacturer is assigned to the lessor before delivery, at which point the lessor pays for and takes delivery of the aircraft and it is leased to the airline. For “used” aircraft, the structure is more straightforward: the airline and lessor would typically enter into a sale and purchase agreement to govern the transfer of title from the airline to the lessor and a lease agreement by which the airline can then take the aircraft immediately back on lease.

 

Even with changes to accounting rules eroding some of the benefits of lease structures for airlines, these transactions continue to be advantageous for both lessors and airlines alike for a number of reasons.

Airlines may benefit from the continual renewal of their fleet through SLB transactions by avoiding those maintenance obligations that arise around the six year mark. Pricing is another key driver. Whilst lessors, who typically pay a premium for aircraft from manufacturers compared to airlines, will often be able to partially benefit from the airline’s more desirable pricing, the airlines themselves benefit from a sort of arbitrage. The discounts they typically obtain from manufacturers as well as ongoing price escalation usually means that an aircraft is worth more at delivery than at the time the order was placed. This is a pure cash “windfall” for an airline, which can be reinvested into its business, although some airlines do chose to amortise it over the duration of the lease term.

when a lessor buys an aircraft from an airline in a SLB transaction, they know what they are getting and when they are getting it; there is no forward-looking gamble on market conditions and, in particular, there is no guess-work around the price of the aircraft

Timing is also important: SLBs give lessors access to next-generation aircraft even where they have not placed orders for them. The alternative (at least for lessors looking for new aircraft) is to establish their own order book. But if they do this, they need to factor in price escalations and the uncertainty of the future aviation market (not to mention the uncertain future value and even utility or desirability of that particular aircraft or aircraft type). Further, order books come with the inevitable conundrum of pre-delivery payments – and the market to finance them is not the easiest to navigate.

With a significant number of new lessors entering the fray over recent years, SLBs have become a particularly attractive tool, enabling these new entrants to increase both their fleet size and their breadth of clientele in one move. Unfortunately for operating lessors, the desirability of the product for airlines means that the market is now super-charged.

Partly as a consequence of this, lease rates are at record lows and a lessor that wants to be competitive in this space will need a low cost and diversified funding base. They would also be well advised to mitigate their credit position by diversifying in relation to both airlines and jurisdictions. This does, of course, assume that all lessors will get the opportunity to participate, which is by no means a certainty. Market anecdotes suggest that whilst the pool of suitors for airlines offering SLB transactions is often vast, many airlines are now seeking to limit the number of participants in their RFPs to enable them to run a manageable process.

The inevitable consequence of a competitive process is that lease provisions are being more keenly fought over and lease rate factors are being pushed down. We understand that even lower calibre airlines are now requesting half-life return conditions and shorter lease terms. Lease provisions and pricing are an area where lessors need to exercise caution. It is all very well offering “rock bottom” lease provisions and pricing now, but experience suggests it can be difficult to improve them again even if the market picks up (or at least, there will be a time-lag before lessors can do so).

Meet the Team: Florent Rigaud

We are very excited to welcome our new Paris team, as we have now been joined by partner Victoria Westcott and counsel Florent Rigaud, as well as senior associate Elaine Porter (joining shortly) and associate Abdullahi Mohammed.

This new team brings significant diversification to Reed Smith’s global asset finance capability, adding particular expertise in working with lessors to our existing strengths on the financing and airline sides. Our colleagues in Paris are currently the only English and French law qualified team practising in both the English and French languages, giving us a unique ability to serve our clients not only in the United Kingdom and Europe, but throughout the Francophone world.

Florent’s client base includes a number of operating lessors, and he has kindly agreed to be interviewed for our blog – we hope you enjoy! Continue Reading

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