The impact of coronavirus (COVID-19) on aviation finance

The impact of coronavirus (COVID-19) on aviation finance

Banking and Finance analysis: The coronavirus (COVID-19) pandemic will considerably impact the aviation finance sector. Experts from Reed Smith Asset Finance team in both London and Paris have analysed the current situation through this new analysis article. The participants are Richard Hakes, partner, Victoria Westcott, partner, Florent Rigaud, counsel, Spiros Zavitsas, senior counsel, Ashleigh Standen, associate, Rohan Soni, associate, and Deena Smith, trainee.

What impact is coronavirus likely to have on the aviation finance sector?

The impact will be like nothing we have seen before. Governments across the globe have implemented strict measures in an attempt to contain or delay the spread of coronavirus. A quarter of the world's population is now living under some form of lockdown, and the pandemic and accompanying global travel restrictions have decimated the aviation industry—not to mention of course, the human cost.

There are projections that airline revenues could drop by 70% or more during April and May 2020, and Moody’s have downgraded airlines to ‘negative’. During previous economic downturns, stakeholders in the aviation industry have often had time to adjust and to take measures to preserve liquidity and cut costs, restructure or refinance. However, to date governments have told airlines in no uncertain terms to find their own private sources of finance, and not to expect extensive bailouts.

In an environment where demand not just for travel, but also for advanced bookings, has completely evaporated, industry leaders had been hoping for a targeted aid package. It is now clear that this would only be considered as a measure of last resort, and even then, only on an airline-by-airline basis when that carrier has exhausted all other avenues. This poses a serious concern when the International Air Transport Association estimates that global airlines will need up to $US200bn of government support to help them survive and has warned of an ‘apocalypse’ if governments do not step in and provide support, predicting worldwide revenues from ticketing could drop by $US 252bn if the current restrictions continue for three months. The Centre for Aviation predicts that, by the end of May this year, most airlines in the world will be bankrupt.

On 25 March 2020, the US approved a coronavirus bill that included $US25bn of assistance for passenger airlines to pay their employees, and another $US 25bn available for loans or loan guarantees. Cargo airlines will receive $US8bn and industry contractors will get $US3bn. In the UK, the government is also discussing a package that would assist airlines and airports, and has announced VAT deferrals and grants to cover the salaries of employees—but it has also stated that financial support from taxpayers for individual airlines would only be a last resort. The Indian government is proposing a $US1.3–1.6bn rescue package for the country’s aviation industry. Numerous other countries have also announced measures to protect their own aviation sectors.

Coronavirus creates previously unheard of challenges—and the aviation industry faces a fight for survival of an indeterminate length.

What issues could arise in relation to aircraft leasing arrangements?

Airlines have seen a huge fall in their revenues by virtue of an almost complete inability to operate, but also because of a drop in consumer confidence around future bookings—coming at the time of year when the travelling public’s attention is often turned to summer vacations, and advance ticket sales are therefore usually strong. If fewer people are flying, it becomes harder to make lease payments. Aircraft leases are typically ‘hell or high water’ agreements (which means that the lessee’s obligations must be performed no matter what happens and regardless of any difficulties it has in doing so)—and therefore even without clear revenue streams, airlines are still liable to make lease payments. However, it is all very well for a lessor to have a contractual entitlement to be paid, but clearly if an airline does not have the liquidity to do so, it is no one’s interest for lessors to drive their customers to the wall at this challenging time (and lessors are not doing so).

The options for parties at this point in time are: (i) the airline continues to pay lease rentals, causing it to burn through what limited cash reserves it may have (this will not be an option for many airlines and even for stronger credits this is likely to be viable only for six months or less); (ii) the lessors extend some goodwill in the form of payment holidays, waivers, or temporary decreases in lease rental rates; (iii) the airline stops making payments and defaults under the lease agreement; or (iv) the airline obtains or draws on a line of credit to enable it to maintain its payment obligations.

It is undesirable for lessors to accept the early return of aircraft or termination of lease agreements—or to take enforcement action—at a time of such market uncertainty, as it would be very difficult to re-lease the aircraft into the fleet of another airline given that the global demand for flying has decreased so significantly. Most lenders and lessors seem to be working with their airline customers to waive or restructure payment schedules. In part, this may be a bet on the airline’s survival. But it is also a pragmatic reflection of the reality that creditors find themselves facing right now—even where defaults are clearly continuing, enforcements and the exercise of other steps (beyond the mere documentary reservations of rights) are severely hampered in an environment where many courts and public offices are closed, many airports are at least partially locked-down, and it would take a brave person to put a definitive value to a hard asset. The go-to solution of repossessing and repositioning assets with stronger credits or in more buoyant markets is not currently an option, and any lessor that did successfully reposes is then likely to be faced with mounting storage and maintenance costs.

We have seen a number of requests for support on sale and leaseback transactions—lessors and investors who are in a position to purchase aircraft at attractive prices may well be able to ride to the rescue of airlines in need of liquidity. This market has also created an opportunity for new entrants, with private equity and investment fund clients looking to capitalise on the low asset cost, working with the lessors and asset managers to acquire aircraft and other aviation assets.

How could pre-delivery payments finance be affected?

Pre-delivery payment (PDP) financing is an integral part of the commercial aircraft production process, used by both airlines and aircraft lessors. However, as a result of the coronavirus outbreak, the aircraft deliveries schedule is uncertain for the near future because the airlines are seeking to defer aircraft deliveries and the aircraft manufacturers are facing supply chain problems of their own.

Anecdotally, airlines are already negotiating with Original Equipment Manufacturers to push out orders. While Airbus have reported that the vast majority of airlines are still paying their PDPs (with March 2020 having not looked dissimilar to February 2020) they have also publicly acknowledged that customers could seek to cancel or postpone deliveries as the crisis continues to escalate. Even if a customer is willing and able to take delivery, clearly the logistics of doing so right now would make it much more complicated than usual and airlines have voted with their feet—it is possible to see scores of Airbus A321s parked in Hamburg, and an unusually high number of Dreamliners parked in South Carolina, for example. A glimmer of a silver lining is that this has given rise to the opportunity for Airbus to push the use of ‘ETOT’, their Electronic Transfer of Title tool, which enables remote deliveries without large teams attending the delivery centre.

We anticipate that securing financial support for PDPs is likely to become more challenging, and much like in the Global Financial Crisis, PDPs will become a less attractive proposition for financiers. PDPs can be payable to manufacturers several years before the delivery of a new aircraft, and is essentially unsecured finance. This makes it much less attractive to lenders than secured finance, especially with the increased regulatory capital constraints that all bank lenders are facing. The number of commercial banks active in the PDP market may therefore diminish (although greater export credit agency support may be provided as part of an increase in permitted state aid).

If an airline defaults during the pre-delivery period, the best prospect the financiers have for recovery is usually to step-in, pay the remainder of the PDPs and take delivery of the aircraft (rather than to be an unsecured creditor of an insolvent airline). It is likely to become more challenging for financiers to get comfortable with PDP finance in an environment where their ‘out’ is undesirable: they do not want to take manufacturer credit risk, and they certainly do not want to be faced with needing to enforce their step-in rights under the purchase agreements (and so pay for and take delivery of the aircraft) when there is a diminished global demand for these assets. If nothing else, we anticipate that this will push up the price of PDP finance.

In an environment where there are serious questions around airline solvency, manufacturers will also need to be realistic about the ‘take-out’ price (the amount that the financiers need to pay to purchase an aircraft in the event of airline default) and whether this is sufficiently attractive to financiers and lessors.

Are the risks arising from coronavirus likely to be mitigated by force majeure clauses or any other provisions?

We have seen a significant number of requests for advice on aviation contracts of various kinds, particularly in relation to ‘force majeure’ clauses, as parties look for ways to minimise, waive or redistribute the payments they are required to make in the face of significant reductions in income. The China Council for the Promotion of International Trade is able to certify the occurrence of events of force majeure, and it has been reported that more than 1,600 of these certificates have already been issued to Chinese companies to prevent them from breaching their contractual obligations. These requests most frequently relate to the deferment of lease rental payments, as well as the suspension of payments to crew and suppliers.

However, it is usually wrong—at least contractually—to suggest that coronavirus constitutes an event of force majeure under an English or New York law aircraft lease agreement. If there is a force majeure clause in an aircraft lease—which in itself would be rare—then the coronavirus outbreak could eventually qualify as a force majeure event. However, the term ‘force majeure’ has no established meaning in common law, and so absent such a provision, it is highly unlikely that a court in a common law jurisdiction would ever infer the inclusion of a force majeure provision in a contract where the parties had not specifically provided for one. As noted above, aircraft leases are typically ‘hell or high water’ agreements, making the imposition of such a force majeure regime on the parties even less likely.

In the alternative, a lessee may instead seek to invoke the common law doctrine of frustration. Frustration means that a contract may be discharged because of circumstances that either make it physically or commercially impossible to fulfil the contract, or that mean the obligations thereunder are radically different from those undertaken when the contract was entered into. In these circumstances, the parties would no longer be bound to perform their contractual obligations. However, generally speaking, mere hardship, inconvenience or material loss will not frustrate a contract—an event of frustration must be so fundamental as to strike at the root of the contract, rendering further performance impossible, illegal or radically different. As things stand, this could be a difficult argument for an airline to make.

Unlike English law, the French Civil Code contains a general principle of force majeure applicable to all contracts. This regime requires that specific conditions are met, these being: (i) the event is beyond the relevant party’s control, (ii) the event could not reasonably have been foreseen at the time of the conclusion of the contract and (iii) the effects of such event could not be avoided by appropriate measures. These conditions are verified by the judge on a case by case basis.

It should be noted however that, as a matter of French law, the parties are free to contractually exclude force majeure or to negotiate a definition of force majeure and the consequences related thereto in the aircraft lease agreement. The rights of a party as regards a force majeure event will therefore be determined by the contract and a detailed review of the scope of the definition of force majeure, as well as of the provisions set out in the contract, will need to be carried out.

In order to be temporarily or permanently released from all or certain obligations, French airlines may notify lessors that coronavirus constitutes force majeure but, where the contract does not provide for any definition of force majeure, such airlines will need to demonstrate that the common law criteria described above are satisfied as a result of various factual and legal circumstances.  The test is high and by way of example, the French courts were not willing to accept that the swine flu pandemic, the chikungunya virus epidemic or the dengue fever epidemic constituted force majeure.  However, due to the international and national lockdowns as well as all emergency measures which have been and are currently being taken by the French authorities in the context of the coronavirus outbreak, the task of demonstrating force majeure might be slightly easier for the French airlines. In addition, the French government has publicly declared the coronavirus to be a case of force majeure in respect of all contracts entered into with the French state. This will undoubtedly have some persuasive influence over the view taken by the courts in connection with private contracts.

It should be noted that the French law force majeure regime does not excuse a party from its payment obligations under a contract.  Amounts due and payable (such as rent) remain payable, albeit they may be legitimately delayed for force majeure if, for instance, the French airline can demonstrate that it does not actually have means to pay due to coronavirus depriving it of its revenues.

If the French airlines are unable to demonstrate impossibility to perform required by the force majeure regime, then they may also look to the so called ‘hardship’ provisions set out in article 1195 of the French Civil Code which provides that ‘if a change of circumstances that was unforeseeable at the time of the conclusion of the contract renders performance excessively onerous for a party which had not accepted the risk of such a change, that party may ask the other contracting party to renegotiate the contract. The first party must continue to perform its obligations during renegotiation’.  If no agreement is reached between the parties following the negotiations or if a party is not willing to negotiate, the parties may decide to terminate the contract or require a judge to revise or terminate it.

These hardship provisions were included in the French Civil Code only a few years ago. The conditions set out above are likely to be viewed as more flexible than those required for force majeure but, as a market practice, they are usually or always excluded in French law governed aircraft lease agreements and more generally in French law business contracts.  There is therefore no significant case law yet which lessors and French airlines may look to, to determine how exactly French courts may interpret these.

Are there any other practical steps that lenders and borrowers should be taking in relation to their aviation finance documentation?

Act now, and act purposefully.

For all industry participants, a robust plan of action needs to be put in place, and all necessary documentation should be close at hand to enable swift and informed decision making. It may be tempting to be reactive, but that is not a route map to safety.

  1. parties should engage early, especially in light of fragmented working arrangements and, in some cases, less prompt decision making

  2. although—as discussed above—payment obligations are often not subject to force majeure type provisions, most market participants are currently accepting that some sort of waiver, deferral or renegotiation of payment obligations, typically for a limited period, is a necessary approach. However, lessors need to keep in mind both their own obligations to financiers (and so any reciprocal waivers that are required) and their own cash reserves and operating costs

  3. ‘not rushed, but fast’ is the mantra one of our clients is asking its internal teams to follow. Of course, it is fully recognised that airlines need waivers and deferrals ‘now’ and that agreements should be reached promptly. However, this should not be at the cost of certainty and proper documentation, particularly where payment obligations and a challenging market are concerned

  4. check your rights under your letters of credit, guarantees and in respect of any cash reserves. Check that they are in place, current and in conformity with the requirements of your lease. Are any coming up for renewal—and are lead times extended in the current world of home working?

  5. check your financing documentation. What notices or consents need to be given to your lenders or to the agent to report any changed or changing circumstances?

  6. consider the possibility of drawdowns on working capital/revolving credit facilities now for liquidity (and consider also when they may become draw-stopped)

  7. waivers and deferrals help in the short term, but all parties need to recognise that lease agreements and loan agreements are likely to require initially standstill agreements, and subsequently, full restructurings. This will extend beyond aircraft assets, to matters such as airlines’ real estate

Interviewed by Elodie Fortin

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