March 2020
Several airlines have announced their intention to ground their operations in light of Covid-19 and lockdowns announced by a number of countries. EasyJet, Ryanair, Virgin Atlantic and British Airways warned of "significant cancellations" as airlines struggle to deal with travel restrictions and a quick drop in demand. Virgin Atlantic said in a statement a "sharp and continual drop in demand" would lead to 75% of its fleet being grounded by March 26 and 85% in April. This is akin to “mothballing” of the business, a strategy more often used during the downturn of particular industries such oil and gas exploration and manufacturing pending recovery. This article examines, at a high level, resulting issues pertaining to the potential liabilities of the affected airlines and the options they may need to explore in the near-term to try to mitigate their exposure.
Obligations under financing contracts
Interest, principal and rent
Most airlines finance the acquisition of aircraft through financing leases or operating leases. In the case of finance leases, the airline borrows a part of the financing and/or equity finances any balance required to pay for the aircraft. The airline pays interest on the financing and repays the principal upon maturity of the loan and, by doing so, it acquires ownership of the aircraft subject to a mortgage in favour of the lenders. The aircraft appear on the balance sheet of the airline as an asset and the corresponding liabilities appear as debt. For operating leases, the airline leases the aircraft for a prescribed period of time in return for payment of a security deposit, rent, and maintenance reserves. The airline does not acquire ownership of the aircraft, but only a “right of quiet enjoyment”. Under current international accounting rules, the aircraft does not appear as an asset on the balance sheet of the airline.
Depending on the financing structure employed, it is likely that interest, amortisation payments, lease rental payments and certain maintenance reserve payments will continue to accrue under the relevant contracts, notwithstanding the global "lockdowns".
Operating leases typically contain a “hell or high water” clause which provides that the lessee’s obligation to pay rent is absolute and unconditional regardless of any other events except where there has been a total loss of the aircraft (which is covered by insurance). Therefore, the risk of not being able to use the aircraft for a certain period is effectively assumed by the lessee at the point of entering into the contract. However the entire contract should be carefully reviewed to see whether there is any room to suspend payment, or indeed other obligations.
Continuing airworthiness of the aircraft
Airlines have an obligation to maintain in good standing a certificate of airworthiness for the aircraft issued by the relevant aviation authority. In addition, operating or financing lease contracts are likely to have additional obligations on the lessee or aircraft owner in relation to the oversight of continuing maintenance requirements in compliance with the aircraft Approved Maintenance Program (AMP), monitoring of maintenance and recordkeeping. This means that grounded aircraft will still require ongoing performance of appropriate maintenance protocol in order to remain airworthy.
Alternatively, the airline may secure the consent of the lessor to park the aircraft into storage at an agreed location (subject to the current travel restrictions) which in turn requires fewer on-going maintenance tasks.
Either way there will be a maintenance burden and cost for the airlines and also staffing demands for aircraft engineers, who hopefully remain healthy and available.
Whilst in the case of operating leases, airlines normally have an obligation to contribute towards maintenance reserves, these are unlikely to be available for use in the above circ*mstances. Maintenance reserves are often available only toward certain agreed maintenance events (the so-called “qualifying works”).
Airport parking charges
The airlines have obligations to pay taxes and flight charges and in particular, airport parking charges. The airport authorities often have a priority lien on an aircraft in respect of any such charges. These charges are likely to accumulate significantly in respect of the grounded aircraft.
Potential options for the airline in relation to liability management
When faced with this unprecedented scenario, it may be worthwhile for airlines to take legal advice and assess the full the full range of options that may be available to them. We explore some of these options below.
Is Covid-19 a force majeure?
Force majeure is a term generally used to describe those contractual terms which provide relief to a party from performance of the contract following the occurrence of certain events. The underlying principle of force majeure is that the occurrence of certain events is outside a party’s control and therefore that party is, alternatively, (1) excused from performing all or part of its obligations, (2) entitled to suspend performance of all or part of its obligations, or (3) entitled to cancel the contract (this third alternative is rarely seen). A force majeure clause is also not an exemption or exception clause, even though the practical effect of a force majeure clause may be to relieve a party of liability for failure to perform, as exception/exemption clauses are typically concerned with relief from damages due to a particular event (a secondary obligation) rather than relief from a party’s primary obligation to perform the contract.
There is no legal doctrine of force majeure under English law. A force majeure clause must therefore be specifically drafted into the contract if a party is to rely on it. Therefore, the airline must check whether such a provision is drafted in its contracts whether finance lease or operating lease. Where such a provision exists in the contract, the drafting of the force majeure clause will also need to have a certain degree of specificity in order to cover the event in question (i.e. an epidemic/pandemic), and "catch all" or "sweep up" language may not always be effective in bringing a range of extraordinary events into the scope of the provision (although that will depend on the construction of the provision as a whole and taking into account the spirit of the contract). The sample of longer term operating leases (also referred to as dry operating leases) we have reviewed have tended not to contain force majeure clauses. On the other hand, shorter term operating leases (also referred to as wet leases or ACMI which come with aircraft crew, insurance and maintenance), we have reviewed have tended to contain some type of force majeure clause, often specifically covering events such as epidemics and governmental measures (they may even go so far as to specifically capture quarantine restrictions, lockouts and unplanned strikes). However, each contract, whether finance lease or dry or wet operating lease would have been entered under different circ*mstances, and risk allocation may not be straightforward (particularly where the airline has previously undergone a restructuring). Therefore, taking legal advice specifically on each particular contract is advisable.
Material adverse change (“MAC”)
Airlines should check whether the contracts they entered contain MAC clauses, which entitle them to terminate the contracts (or at least, create a basis for negotiation). Whilst the operating leases we have reviewed contain some form of MAC clause these have tended to appear in two sections, firstly, the representations and warranties section, and secondly, in the events of default section. Dealing with the first, they serve as a protective measure for the lessor whereby the lessee essentially represents and warrants that there is no MAC with respect to its financial condition, business or assets. The representation will typically be given at the time of entering into the operating lease, delivery of the aircraft, and then on each rent payment date. Secondly, MAC is often expressly stated as an event of default which allows the lessor to call a default and potentially terminate the lease and repossess the aircraft albeit commercially these rights appear to be theoretical in the current circ*mstances. On the basis of the operating leases which we have seen, MAC clauses do not appear to afford much protection for the lessee and are unlikely to offer much relief in the context of Covid-19.
Illegality, change in law
Whether or not a lessee will be able to argue if other provisions have been triggered in the operating lease (e.g. impossibility, illegality, change in law, will depend on the circ*mstances and the terms of the contract. As things currently stand however, it should be noted that that an illegality/change in law argument is not likely to succeed given that the current restrictions apply to operation in certain geographic areas, rather than to a lessee's own operation of an aircraft/performance of lease obligations.
The doctrine of frustration
If there is no force majeure clause in the applicable contracts, under English law, the legal doctrine of frustration may potentially provide relief when an event occurs that makes it impossible to fulfil a contract. In this sense, force majeure can be differentiated from the legal doctrine of frustration as the latter the focuses on circ*mstances which render the contract impossible to perform - this is a high threshold to meet. If a contract is held to have been "frustrated", the parties are automatically released from their obligations and the contract is discharged.
It may be argued that Covid-19 has resulted in certain contracts being "frustrated". A contract may be frustrated where a supervening event occurs after a contract has been formed, which is so fundamental that it strikes at the root of the contract, which was entirely beyond contemplation of the parties at the time they entered the contract, is not due to the fault of either party, and which renders further performance impossible, illegal or radically different to what was originally contemplated by the parties. The issue with frustration is that it has a very high threshold - mere inconvenience or hardship will not normally warrant a contract to be frustrated. The English courts have held contracts to be frustrated in very exceptional cases, so this is usually a doctrine that, at best, would relied on as a last resort, and which may in the end provide no relief.
Case law on contracts which could not be frustrated:
- In the Hong Kong case of Li Ching Wing v Xuan Yi Xiong [2004] 1 HKLRD 754, a Hong Kong court held that a tenancy agreement was not frustrated when the premises were affected by an isolation order by the Department of Health due to the outbreak of Severe Acute Respiratory Syndrome (SARS) (resulting in a 10-day period in which the premises could not be inhabited). In the court's view, a 10 day period of being deprived the use of the premises was not deemed significant in the context of the two-year duration of the lease, and even though SARS was arguably an unforeseeable event, it did not “significantly change the nature of the outstanding contractual rights or obligations” of the parties. In terms of leases generally, there are no reported cases in England where a lease has been held to be frustrated.
- Bad weather and unforeseen shortage of available labour was held not be sufficient to warrant frustrating a contract (Davis Contractors v Fareham Urban DC).
- Changes in economic conditions/recession where there is a sharp and unexpected fall in property prices was not deemed by the courts to be entirely unforeseen and did not frustrate a contract (Gold Group Properties Ltd v BDW Trading Ltd (formerly Barratt Homes Ltd)).
Case law on contracts which were held to be frustrated:
- Subsequent change in law or circ*mstances which render performance illegal - in Denny Mott & Dickson Ltd v James B Fraser & Co Ltd [1944] A.C. 265, the parties entered into a contract for the sale of timber and leasing (with option to purchase) of timber yard which was rendered to have been frustrated by The Control of Timber Order 1939 which made further transactions under the contract illegal.
- Unexpected delay due to unforeseen events or changes in circ*mstances - In Pioneer Shipping Ltd v BTP Tioxide Ltd (The Nema) [1982] AC 724, the owners chartered the "Nema" in November 1978 for the purpose of conducting a series of transatlantic voyages to take place in 1979 (the charterparty was subsequently also extended to 1980). After one round of voyage, the Nema was unable to load owing to strike action. The strike continued and although the owners were able to use the Nema for intermediate voyages, in August 1979 the parties went to arbitration. It was held that the charterparty (in so far as it affected the voyages of 1979) was frustrated.
- Wars and contracts of a personal nature where the subject matter expires are also examples of cases where contracts may be frustrated.
Notwithstanding the foregoing, one must appreciate the global and unprecedented nature of Covid-19. Depending on how events unfold over the coming weeks and months, it is possible that at some point the frustration threshold may be reached.
Consensual resolution
The current circ*mstances are highly exceptional and we expect it may be unlikely that lessors or aircraft financiers will attempt to enforce their contractual rights without first properly evaluating the range of options available to them. For example, the repossession of an aircraft without the ability to remarket may not make much economic sense, unless of course this is for some other purpose. Therefore, as long as the current circ*mstances continue to exist the primary focus for lessors or aircraft financiers may be the preservation of value in their asset, at least for the time being. Some may reserve their rights (if they take no action) so they are not deemed to waive them through a failure or delay in acting.
pursuant to one/more contractual defaults. We would also anticipate some kind of loss or cost sharing arrangements in order to distribute the burden in the meantime, however, this will likely depend upon the negotiation and bargaining strengths of the relevant parties. It is advisable that any settlements or other bespoke arrangements are properly approved and documented as this will help to minimise litigation risk as the economy recovers.
The views expressed herein are solely the views of the authors and do not represent the views of Brown Rudnick LLP, those parties represented by the authors, or those parties represented by Brown Rudnick LLP. Specific legal advice depends on the facts of each situation and may vary from situation to situation. Information contained in this article may be incomplete and is not intended to constitute legal advice by the authors or the lawyers at Brown Rudnick LLP, and it does not establish a lawyer-client relationship.
