COVID-19: Where to next for airlines and their investors?

By Leo Fattorini, Paul Briggs, Richard Sharman, Dr. Matthias Winter

03-2020

There has been a wealth of articles published over recent days and weeks relating to the impact of COVID-19 on the aviation industry, many of them focussed on the unprecedented challenge currently faced by airlines. While the situation changes on a daily basis, it's clear that the spread of this virus across the globe and the consequent plummet in air travel will have a very material long-term impact on our industry. Some commentators have suggested that by May more than three-quarters of the world’s airlines could be bankrupt, or nationalised. IATA's most recent forecast indicates that airlines will need more than $200 billion in bailout money to sustain operations beyond July.

As we write, airlines across the world have grounded the majority of their fleet, with some no longer operating any aircraft at all – aiming as far as possible to limit costs in the hope that existing cash or credit lines may see them through the crisis, or that governments will come to their rescue. In many cases difficult decisions have been made to temporarily lay off valued members of staff who simply aren't needed to service such dramatically reduced operations.

While the public will be following such news with general interest, for those of us involved in the leasing and financing of aircraft, much of the focus is on how and if airlines will be able to continue to pay lease rent and maintenance reserves or to take delivery of new aircraft, and to the extent they can't, what impact this will have on aircraft lessors and financiers, and what they can and will do about it.

Almost half of all commercial aircraft are now leased by airlines, with the majority of the others subject to other forms of financing. Few airlines have ever had the cash resources to acquire aircraft outright from the manufacturers, and even if they have, a portion of their fleet will usually be leased or financed in any event. And why wouldn't they be, in the recent era of plentiful and relatively cheap liquidity, and an environment where lease rate factors have been steadily dropping.

As airlines now struggle to service their lease rentals or borrowing costs, the relationship between airlines as lessees and borrowers on the one hand, and aircraft lessors and financiers on the other, which has been the lifeblood of the incredible growth of the industry over the past few years, is likely to be tested in the coming weeks and months as never before.

This could, of course, be an epic, existential battle between operator and investor. There's no getting away from the fact that as a result of the current crisis many airlines are likely to default on their contractual obligations, and that this in turn will cause serious difficulties for investors, many of whom have their own linked commitments.

Turning for a moment to the contractual specifics, every well-drafted lease will have a net lease (or "Hell and High Water") clause which in effect states that an airline lessee must pay rent for the duration for the lease term, come what may - even in extraordinary circumstances such as these.

However, for over a year now we have been advising on the ongoing MAX debacle. Airlines that reluctantly accepted "hell or high water" risk allocation on grounding had understandably started asking, "Does this still hold? After a year - or 10 years? What if MAX never flies again?" At the Dublin Conferences in January there was for the first time real debate about the prospect of investors taking some grounding risk and the "triple net" lessor protection corroding in extreme circumstances. More powerful airlines have indicated that they may in future seek that debt become interest only during a grounding.

But for now, there are rarely any qualifications to the fundamental net lease clause.

Against this contractual provision, lessees have been scrambling to explore other potential avenues for respite. Much has been discussed about whether 'force majeure' could come to the rescue of lessees. However force majeure, a contractual provision which broadly-speaking allows some forbearance in the event matters outside a party's control prevent performance of an obligation, is only applicable if expressly drafted into an agreement - and no normal aircraft dry lease contains a clause allowing for an airline not to pay when circumstances outside its control force it (commercially or legally) to ground aircraft. Even in the intensely competitive lessor world we have recently inhabited, lessors or financiers have not yet been obliged to accept such risks to their payment streams. Aside from the inherent risks, to include such a provision in an operating lease would make it very difficult indeed for a lessor to finance or trade the leased aircraft.

In the absence of a force majeure safety net, there's also been discussion about airlines potentially relying on the English law doctrine of frustration on the basis that it has become impossible to carry out contractual obligations. However, as matters stand and putting aside express contractual exclusions, frustration is unlikely to apply here - but that's not to say that judges won't seek to develop or nuance the law in this regard as and when the likely wave of claims arising from COVID reaches the English courts.

So where does that leave us?

In the absence of a legal right to withhold payments, airline executives have been approaching their lessors and financiers seeking rent deferrals and/or other forms of relief. Some airlines may have simply stopped paying without any communication leaving lessors desperately seeking clarification of current positions, all keen at the very least to be treated equally with the lessee's other lessors. While acutely aware of their contractual rights, many lessors are agreeing to such requests.

Even in relation to lessees with historical payment issues where a lessor might now be inclined to call time, in reality there's little point for the moment in seeking to repossess aircraft. In order to do so, the lessor would normally need to send personnel overseas to inspect an aircraft and its records, and potentially deal actively with the local aviation authority. However currently no-one can (or wants to) travel, or even be in proximity with other people. Perhaps more pertinently, what would the lessor do with the repossessed aircraft in any event? It probably can't fly it away and as things stand, there's no certainty on a future home for the asset. How the world has changed from a few weeks ago, when the grounding of Boeing MAXs had so many craving for 737 NGs.

So there we have it – numerous airlines who simply can't pay and are consequently in default of the obligations underlying their most important asset – their aircraft. Lessors who are within their rights to call the default, repossess their assets and claim for losses against a customer, but who are reluctant to do so.

It must never be forgotten that airlines are our industry. It's perhaps a bit trite, but worth reminding that without them there wouldn't be any aircraft lessors, aircraft financiers, aircraft and engine OEMs, parts suppliers, MROs, aviation insurers, airports – or aviation lawyers! And, although everyone in the industry is certainly suffering to some degree, surely none more so than the airlines – who now need the help and support of everyone in the industry like never before.

Yes, some airlines have managed to be incredibly successful, building up vast amounts of cash and delivering material shareholder value, however for most, every day is a struggle. A battle to make even a meagre margin in an ever-more competitive market, ever-increasing regulation (consumer protection and otherwise), environmental and other taxes, buffeted by fuel prices and hedging positions, currency movements, trade wars, and in recent months by "flight-shaming" – so many of these factors entirely outside their control.

No-one operates an airline without hoping to make a profit, but for many employees it is about more than that - a genuine passion for everything the airline stands for - travel, exploration, adventure, bringing people together. And of course, there's the enormous economic benefit, measured at trillions of dollars, derived from the industry through commerce, freight and tourism.
Although there are some who would happily see airlines in general, with the unavoidable environmental impact they bring, dwindle into much smaller entities. And of course there will be airlines that have prudently managed their businesses and cash reserves who would be quite understandably content to see some of their competition fall away.

However most of us, while keen to support a more environmentally-friendly industry, realise that the world needs and benefits from airlines. After all, over 60 million jobs are sustained by the aviation industry. And ultimately everyone is going to need airlines more than ever before once the virus fades and the work begins on rebuilding broken economies and reuniting families and friends.

With this in mind, our sincere hope is that the focus will start to turn away from legal rights and options resulting from defaults, instead to thoughts as to how to restructure agreements so the airline industry can recover from this 'once in a generation' event. Turning to positive, constructive, future-facing conversations on ways in which we can all play our part in rebuilding our industry and saving and protecting the jobs of everyone involved in and reliant on it.

Although battered, surviving airlines will also need to play their part in this. Maybe with a more sympathetic approach to the environmental concerns, increased flexibility around bookings and customer service, and in our world, perhaps being a bit more accommodating in lease and finance negotiations – not to make it easier for lessors to call defaults and repossess aircraft – but to bring the trust back to the vital symbiotic relationship between the investor and the airline.

That said, with renewed focus on certain lease provisions such as the hell or high water clause, delayed delivery and walkway provisions, business continuity covenants and events of default, no grounding covenants and so on, all this remains to be seen...

In the meantime, all of us in the Bird & Bird Aviation Team wish everyone - our clients, other friends and competitors alike – all the best during these uncertain times as we each seek to play our part in ensuring the survival and continued growth and success of this great industry.