As a result of the COVID pandemic, with the resulting payment defaults amongst several airlines , the past few years have seen a surge in interest in distressed debt opportunities within the aviation sector. One particular area which has seen a lot of attention has been Japanese tax leasing – namely the Japanese operating lease (“JOL”) and Japanese operating lease with call option (“JOLCO”) products.
JOLs and JOLCOs have been staples of the aviation market for many years. Both are essentially operating leases with an investment of Japanese equity, typically provided by a Japanese corporation with tax capacity. This is usually twinned with limited recourse senior debt from a Japanese bank or a Japanese branch of an overseas bank, such that the credit of the underlying lessee is integral to the transaction as the revenue flowing from the lease would be used to pay the debt.
Whereas a JOL is essentially a simple operating lease (under which the aircraft should return to the lessor at the end of its term), the JOLCO includes a purchase option, pursuant to which the expectation is that the relevant lessee would exercise that option rather than putting the aircraft into its contractual (and costly) “full life” redelivery condition. As such, JOLCOs have, in some quarters, been regarded as a form of quasi-financing for the lessee (whether an airline or an operating lessor), unlike JOLs where there is a substantive operating lessor/servicer entity in place.
These products appear to have generated a lot of attention from alternative investors, attracted by the prospect of realising the metal value of the asset itself in the long-term once aircraft values have recovered whilst obtaining a short- to medium-term upside through a contractual claim against a defaulting lessee. A particular attraction has been the significant damages claim that might be brought under JOLCOs for failure to put the aircraft into its “full life” condition once the leasing of the aircraft has been terminated (and assuming that the airline can be disbarred from taking title to the aircraft as a consequence of its default). However, even under a JOL, the prospect of a damages claim for the net present value of future rental together with any redelivery costs (even for “half-life” condition) can be attractive.
Whilst in most aviation defaults, the lenders would either (i) leave a substantive operating lessor/servicer to deal with its defaulting airline(s) for a prescribed period of time or (ii) remove that lessor (often through enforcement of share security) but keep the underlying operating lease in place, the circumstances are different here. Given the economics, there is an effective “double default” at both the lessee and lessor levels (although, as a technical matter, there is unlikely to be an event of default under the loan agreement (the loan instead being accelerated by way of a “non-fault” mandatory prepayment event) with the lessor protected by the limited recourse provisions, unless the non-payment or other breach has been caused by its own malfeasance).
In the case of JOLs and JOLCOs, the enforcement strategy has tended to separate enforcement against the aircraft from enforcement against the defaulting lessee. Share charges are rare in JOLs and JOLCOs, so enforcement against the aircraft would ordinarily be by way of foreclosure under the mortgage(s), a process itself dictated by the governing law of the mortgage being used. In most cases, this would be the “primary” mortgage (often a New York law mortgage) rather than any “secondary” mortgage in the state of registration of the aircraft. Enforcement against the defaulting lessee, on the other hand, would be by way of the relevant security assignment(s), pursuant to which the relevant security trustee would be exercising its rights as assignee of the lessor’s interests under the lease (including any claims it may have against the defaulting lessee).
The enforcement strategy itself has generated a lot of controversy, especially in a Japanese market traditionally based upon long-standing relationships. The ongoing Chapter 11 cases involving JPA No. 49 Co., Ltd. and JPA No. 111 Co., Ltd. (together, the “JPA Entities”), filed in December 2021, offer a good example of this – Case No. 21-12075 (DSJ) (the “Chapter 11 Case”). As borrowers and lessors under JOL structures, their lessee (Vietnam Airlines) was in default. The debt positions were bought up by Fitzwalter Capital Limited who, in turn, sought to enforce a claim against the airline (but not, at that time, the aircraft itself) through the English law security assignment and without notifying the JPA Entities (something which they were legitimately not required to do contractually). As a protective measure, once they found out about the enforcement steps, the JPA Entities filed for Chapter 11 and shortly thereafter procured a stalking horse bid sufficient to pay out the senior debt plus an additional US$ 5 million.
Fitzwalter sought to throw out the case, but its efforts ultimately failed for various reasons. Amongst other things, the court asserted that the JPA Entities’ Chapter 11 petition “was filed in a subjectively good-faith effort to maximize recoveries of all stakeholders by making the best of a difficult commercial situation” and that the JPA Entities had sufficient interest in the leases (in respect of which, even though assigned as security, they still had an equity of redemption) to form part of a sale to the stalking horse bidder. As of the end of March 2022, the stalking horse bid to purchase the aircraft and related leases has been approved by the court.
The fact that the JPA Entities were lessors within a JOL structure may have meant that their residual value in the aircraft incentivised them to take extensive action to protect their assets, something which a JOLCO borrower may have been less inclined to do given the lessee’s substantive economic interest in the aircraft in a JOLCO structure. It certainly seems to be the case that, being entities affiliated to a substantive leasing and financial services provider, the JPA Entities were able to procure a stalking horse bid in short order over the festive period and that the existence of such stalking horse bid was instrumental in upholding the Chapter 11 proceedings.
As a consequence of the Chapter 11 Case, there will no doubt be renewed interest amongst borrowers in transfer rights under future loan agreements (themselves already tightly restricted in the JOL and JOLCO markets given the tax implications), the identity of security agents/trustees and facility agents, and whether notice needs to be given to obligors when security is being enforced. Yet the path to enforcement is not necessarily closed off; even the court in the Chapter 11 Case acknowledged that Fitzwalter was “not contractually restrained from pursuing a course that will yield a lesser recovery that is likely to harm parties other than itself” and did not seek to question its subjective intent. However, the Chapter 11 Case may stand as a cautionary note to those looking to invest in distressed assets; the upsides may be there, but the equity can be very willing to fight back.
For more information on JOLs and JOLCOs see, JOL-ted into action: how leasing is changing asset finance.