Pitfalls and Opportunities for Airlines, Lessors, Lenders and Aircraft Financiers, and Alternative Capital Providers
COVID-19 Cuts a Harsh Path Through the Aviation Sector
The COVID-19 pandemic has profoundly affected the economy, and aviation has been among the most broadly and deeply impacted of all “COVID sectors.” Drastically reduced demand for business and leisure travel, as well as demand for aviation related services, has created distress in every corner of the aviation industry. From airline carriers to manufacturing, MROs (maintenance, repair, and operations), aircraft leasing, services, airports, and other ancillary industries such as hotels, auto rental companies, and even luggage companies, the pain has been widespread. What’s more, industry experts do not expect a full recovery until 2024.
The aviation sector generally was not built to deal with a crisis of this magnitude. Within this framework, airline carriers must confront the particular challenges imposed by business models that have limited flexibility owing to large, fixed capital investments. To survive, air carriers are searching for ways to bolster their liquidity to tide them through a prolonged downturn and, at the same time, to address excess fleet capacity, defaults on credit documents and aircraft lease documents, and significant customer ticket liability and refunds.
Just as with previous crises, Chapter 11 is once more proving to be a powerful tool to address the current crop of challenges, as several airlines have recently availed themselves of Chapter 11. Included among the latest group of airline casualties are Grupo Aeromexico, Avianca and LATAM. What they all have in common is that they are non-US based carriers. It is remarkably easy to establish jurisdiction in the United States to support a Chapter 11 case for a non-U.S. air carrier. All that is needed is some peppercorn of property in the U.S., which might be as minimal as gate slots at an airport, a ticket counter, or even just a bank account or attorney retainer funds.
Why is Chapter 11 Appealing for Non-U.S. Airlines?
First and foremost, aviation is a global business with market participants and creditors from all around the world, making Chapter 11 a natural choice both for operational and balance sheet restructurings. The ability to access the protection of the automatic stay, which purports to have global effect, can be critical for non-U.S. airlines to protect non-U.S. assets. Further, the ability to bind creditors subject to U.S. court jurisdiction, regardless of where they are located, aids in both putting teeth into the automatic stay and also enforcing the ultimate terms of the restructuring.
Second, due to the reduced demand for air travel, airlines may use Chapter 11 to conduct and implement fleet rationalization exercises to address and right size their fleet of aircraft. In this connection, Section 365 of the Bankruptcy Code, which permits the rejection or assumption (including on modified terms) of executory contracts, such as operating leases for aircraft, engines and other parts as well as maintenance and service arrangements, is an extremely useful tool for conducting a fleet rationalization exercise or other operational fixes for an air carrier business.
Third, Chapter 11 affords an air carrier the opportunity to raise fresh capital during the course of the Chapter 11 case in the form of debtor in possession (DIP) financing. Indeed, as is typically the case when an industry suffers a cyclical blow, air carriers have become sufficiently distressed that they have captured the attention of alternative capital providers that see opportunities in the aviation sector. For this reason, alternative capital providers have led or participated in several DIP financing arrangements. In some of these instances, the DIP providers have made clear their intentions to convert their DIP financing position into equity under the terms of the Chapter 11 plan and ultimately to take a controlling stake of the equity in the reorganized air carrier upon completion of the Chapter 11 case.
Finally, the availability – or not – of government support for the sector, such as the CARES Act in the United States, has been a material factor in the current environment. How long will the various state aid programs continue and what will be the depth of government support for national, flagged or private carriers at a time when many economies are struggling?
There are some lessons for industry participants in view of these themes.
Tips for Air Carriers
It is critical for non-U.S. air carriers availing themselves of Chapter 11 to understand both the cross-border dynamics of a Chapter 11 case, such as enforcement of U.S. court orders in non-U.S. jurisdictions, as well as intersections with other areas of international law. One example relates to the aircraft protocol (Alternative A) of the Cape Town Convention (CTC), which seeks to standardize transactions involving movable property across international borders.
While the United States is a signatory to the CTC, it has not signed on to the provisions governing insolvency scenarios – namely Alternatives A and B of the CTC. Nevertheless, Section 1110(b) of the U.S. Bankruptcy Code, which governs the treatment of operating leases for aircraft (as distinguished from finance leases) under Chapter 11, closely tracks Alternative A of the CTC and, indeed, Alternative A was based on Section 1110(b). However, Section 1110(b) appears to apply only to U.S. carriers. To thread the needle in these circumstances, a custom and practice has evolved in Chapter 11 cases for non-U.S. carriers whereby the air carrier debtor and applicable lessors have generally adopted the same procedures and played by the same rules that would otherwise be applied under Section 1110(b) of the Bankruptcy Code or Alternative A of the CTC, even though not literally required for non-U.S. air carriers.
In addition, non-U.S. air carriers will need to consider how they will obtain recognition of their Chapter 11 case in all relevant jurisdictions in which it operates outside the United States. Will the carrier need to pay local creditors in full? Will a parallel proceeding be required in the debtor’s home jurisdiction? Will the courts in that jurisdiction cooperate?
Finally, the participation of foreign governments in the provision of state aid can be a critical case dynamic for national or flagged non-U.S. carriers.
Tips for Aircraft Lessors
Virtually every air carrier Chapter 11 case will involve a fleet rationalization exercise, whereby the air carrier right sizes its fleet to keep aircraft necessary for future operations while rejecting or modifying burdensome leases and aircraft financing arrangements.
In this regard, Section 365 of the U.S. Bankruptcy Code affords a Chapter 11 airline debtor a unique opportunity compared to other insolvency regimes. Under Section 365, the debtor air carrier may choose to assume (i.e., accept and continue, including on modified terms with the consent of the lessor) or reject (i.e., terminate) its executory contracts such as operating leases for aircraft. Damages arising from rejection of an operating lease will be categorized as unsecured claims, which are frequently paid out at pennies on the dollar.
Some air carriers have pursued their fleet rationalization exercise by using the threat of Section 365 rejection coupled with a “reverse Dutch auction” process. In these circumstances, the air carrier invites its lessors to bid to continue to do business with the air carrier, and its lessors end up competing with each other for the right to keep their aircraft leasing arrangements with the carrier, albeit on modified (reduced) terms. Those lessors whose bids are not selected in the reverse Dutch auction will have their leases rejected pursuant to Section 365.
In contrast to operating leases, which are considered to be “true” leases, finance leases are treated as secured financings rather than executory contracts. Thus, finance leases are not subject to assumption or rejection under Section 365. Instead, finance leases will be treated like any other secured debt under Chapter 11. The finance lessor will have a secured claim up to the value of the aircraft (or other collateral) and an unsecured claim to the extent of any deficiency in the value of the collateral. The airline debtor may seek to continue the financing arrangement (either by keeping the existing terms or attempting to negotiate or impose a change in terms). Alternatively, the debtor may seek to return the aircraft or other collateral to the finance lessor either in full satisfaction of the finance lessor’s claims or together with an unsecured deficiency claim to be treated as part of the pool of general unsecured claims.
Lessors should determine:
- whether their “lease” is an operating (true) lease or a finance lease;
- the current market value of their aircraft or other collateral if sold on the open market; and
- the current market rates for their collateral if leased on a short term basis, including power by the hour (PBTH) arrangements, which have recently been adopted with increased frequency in light of the enormous uncertainty that current market conditions impose on all market participants. PBTH arrangements are therefore a convenient stopgap measure.
Tips for Lenders and Financiers
Distress for air carriers and related industries touches on all aspects of finance - leveraged finance, structured products and project finance. Lenders and financiers with active positions in the market should understand that sooner or later their interests are likely to be affected by a Chapter 11 filing.
For such lenders and financiers, it is critical to determine the value of their collateral and the extent to which they are secured or undersecured, as these considerations will largely drive their leverage and treatment in the event of a Chapter 11 case.
For alternative capital providers (ACPs), on the other hand, the current distressed environment provides opportunities to acquire ownership interests in air carriers at depressed prices. The use of DIP financing can be an attractive tool to facilitate this, given the many protections afforded by the DIP financing provisions of the Bankruptcy Code and the ability for DIP financiers to influence the progression of a Chapter 11 case. For example, the ACP, as DIP lender, can set out case “milestones” in the terms of the DIP loan which require the air carrier debtor to achieve certain goals by certain dates. Typical milestones include filing of the proposed Chapter 11 plan, confirmation of the Chapter 11 plan, and emergence from Chapter 11.
Finally, for Chapter 11 cases involving national or flagged air carriers, ACPs looking to take ownership interests may be able to partner with the applicable national government to further drive the Chapter 11 case.
Conclusion
The COVID-19 pandemic has created significant distress for air carriers and related aviation businesses, though Chapter 11 is once more proving to be a powerful tool for airlines to restructure and survive the crisis. While lenders and lessors should be aware of the pitfalls of Chapter 11 and a potential fleet rationalization exercise, the possibility of Chapter 11 provides opportunities for these creditors as well as ACPs through DIP financing and other opportunities.
