Initial Reserve Credits When Leasing a Used Aircraft: Some Thoughts

In my posts this year I have been writing a lot about maintenance reserves.  This focus is not misplaced.  The maintenance reserve section is one of four aircraft lease sections where the lawyers on a deal can make a commercial difference–either positively or negatively.  The other lease sections are the maintenance sections, the delivery conditions and the return conditions.

My work for the last year has been focused on reviewing lease agreements in connection with the purchase of leased aircraft–and an unsurprising pattern has emerged in these reviews.  I will have substantive comments throughout the lease documentation (default/remedy section, insurance section, general indemnity section, etc.), but when I finish the review and prepare a summary highlighting the most serious problems with the lease documentation, the list is heavily weighted with maintenance reserve and return condition issues–mainly because these are the issues that will have a material and inevitable financial impact on the lessor.  If there is a mistake in the general indemnity, insurance or the default/remedies section, it’s highly unlikely such mistake will ever have any impact on the lessor.

As a consequence, when my client discusses my comments with me and then with the seller of the aircraft, my client’s focus is on these maintenance reserve and return condition issues.  And if a purchase falls apart during the due diligence stage, it’s very likely going to be because of either an unsatisfactory aircraft inspection or deficiencies in the maintenance reserve and return condition sections of the lease documentation.  The deal is not going to fail because, for example, the scope of the general indemnity isn’t broad enough.

With the above in mind, here are some thoughts on the maintenance reserve provision dealing with initial credits for reimbursable maintenance (aka “lessor contributions”).

1. Start Date. When a lessor is offering to lease a used aircraft to a lessee the lessor will generally offer to provide the lessee with credits that the lessee may use in connection with the first reserve reimbursable maintenance visit (major airframe check, engine performance restoration, etc.) during the lease term.  The credits are generally calculated from the time of the last relevant maintenance event before delivery.  One of the things that I look for when reviewing this lease provision is whether the lease documentation is clear about the start date for the calculation of the credit.

For the airframe and the landing gear, where the checks/overhauls are generally calendar driven and the workscope well-defined, the start date should be obvious from the aircraft’s maintenance records.  Similarly, for the engine LLPs, assuming the aircraft records and lease documentation accurately reflect cycles since new and have back-to-birth (including thrust usage) traceability, the start date and the credit calculation should be just a matter of math.

But for the engines and APU, the timing of performance restorations is driven by operating condition and not by calendar time, hours or cycles, and the workscope for an engine restoration can be heavy or light.  Consequently it is very common for a lessor and lessee to disagree about the start date for the initial credit on the engines and APU–that is, disagree on the amount of the initial credit.  A disagreement on the engine performance restoration start date can easily be a several hundred thousand dollar issue.

The best practice here is to agree either the start date or the amount of the initial credit during the lease negotiation.  If the start date is not clear from the lease documentation, then I will recommend to the buyer of the aircraft to agree the start date in the lease novation documentation.

2. The Method of Calculation. Once the start date is agreed there are a couple ways to calculate the initial credit–the pro rata method and the rate-times-hours/cycles/months method.

Under the latter method, the calculation of the initial credit is the simply the applicable base year (unescalated) maintenance reserve rate multiplied by the number of hours, cycles or months (as applicable) since the last relevant maintenance event.

Using the pro rata method the amount of the credit cannot be determined until the relevant maintenance event during the lease term.  At that time the full reimbursable cost for the visit is allocated pro rata between the usage before the delivery date and  the usage after the delivery date, with the lessor obligation to provide a credit for the usage before the delivery date.  For example, if an engine performance restoration costs $4M, the “start date” was two years before the delivery date and the performance restoration was started two years after the delivery date, then the initial credit would be $2M.

Lessors generally don’t like the pro rata approach because (1) it shifts the risk early maintenance (especially respect to engines) on to the lessor (because the denominator in the pro rata calculation is smaller for early maintenance) and (2) it shifts part of the risk of the final cost of the maintenance on to the lessor (because the lessor’s credit is not capped at the per hour/cycle/month rate, but instead is calculated using the actual reimbursable cost of the maintenance event).

The use of the pro rata method for engine performance restorations is especially risky for lessors–because an engine can come off wing early for condition reasons and because the cost of performance restorations is notoriously difficult to predict/control.  To take an extreme example, if an engine is driven off wing for a performance restoration on the first day of the lease term, the pro rata approach would result in the lessor bearing 100% of the cost of the performance restoration.

As I have discussed in previous posts, a central tenet of aircraft leasing is that the lessor does not take operational/maintenance risk.  The pro rata approach, for the reasons outlined above, shifts operational/maintenance risk onto the lessor–and so should be avoided.

3. Engine LLPs. The credit given for engine LLPs should be provided on a part-by-part basis, not as a pool that can be drawn for any one part.  Like the pro rata approach discussed above, allowing the lessee to draw on a pool of credits for the replacement of any one part shifts the risk of early removal to the lessor.  Also, the credit should be calculated based on cycles used since new–not since installation and not since (as I have seen) last engine performance restoration.

4. Other Considerations. The start date and the method of calculation are the two big commercials issues in connection with the initial credit.  Here are some further less controversial recommendations:

(a)  The initial credit provisions should apply only to the first reimbursable maintenance event during the lease term.

(b)  The initial credit should apply only to reimbursable maintenance events and only to the extent the maintenance event is reimbursable.

(c)  The obligation to pay the credit should be conditioned on the same conditions as the reimbursement of reserves (e.g., no continuing lessee default).

(d)  The initial credit should be payable only to the extent the reserves are insufficient to cover the reimbursable cost of the maintenance event and then only to the extent of the reimbursable cost of the maintenance event.

(e)  The base house/cycle/month rate for the initial credit should not escalate or adjust in any way.

I know some you will be saying “no duh, dude” to (a) through (e) above, but it’s common for a lease to be silent on one or more of these issues.

5. Novation. As discussed in a previous post, when acquiring a lease by novation or assignment, the novation/assignment agreement should have a provision in which the lessee confirms which credits have already been satisfied and, unless the lease documentation uses the pro rata method, the amount of the remaining credits.

Maintenance Reserves for LLPs: Some Random Thoughts

I have been reviewing a lot of leases recently, and among the various lessors and forms of leases I am seeing that there is almost always a drafting or conceptual issue with the engine LLP reserve provisions.  This post will discuss a few of those issues.  Some of the issues below are also touched upon in less detail in a previous post.

Used LLPs

Several years ago a very sharp lessor tech officer pointed out that the lease agreement we were negotiating should have an adjustment to the LLP reserve reimbursement amount where the replacement LLP (for which reimbursement is being sought) is a used LLP.  The use of used LLPs by airlines and MROs is not uncommon, and the tech officer’s view was that the lessee should not be able to draw, without limit, from reserves or any lessor contributions (for utilization prior to the delivery date) for the cost of a used LLP.

For example, why should a lessee be allowed to draw reserves, without limit, for the cost of a used LLP where the replacement LLP has less cycles remaining than the replaced LLP had at removal (e.g., in a replacement required because of FOD or failure)?  Similarly, why should a lessee be allowed to draw lessor contributions, without limit, for the cost of a used LLP where the replacement LLP has less cycles remaining than the replaced LLP had on the delivery date? Underlying these questions is the (correct and accepted) premise that a lessor should at all times have LLP reserves for an LLP that reflect the utilization of that LLP since new.

The tech officer and I came up with some unfortunately complicated drafting adjusting the LLP reserve reimbursement amount in the above scenarios.  I say “unfortunately” because I value simplicity in drafting–easier to negotiate, easier to administer, easier to enforce.  Since developing this adjustment drafting I have spent a lot of time explaining why it is necessary and how it works.

In the numerous leases I have reviewed recently not one has made a distinction between used LLPs and new LLPs in the reserve reimbursement section, and I so started to wonder whether maybe I was missing something.  Why didn’t these other lessors care about the used LLP issue?  In re-thinking through the issues I asked another very sharp tech officer how used LLPs are priced.  He told me that used LLPs are generally priced pro rata (straight line) to the price of a new part–so an LLP with 75% life remaining would cost 75% of the catalog price of such part.

If we assume that used LLPs are always priced on a straight-line pro rata basis and if the working assumption for drafting is that the reserve balance and any lessor contribution amount for any LLP reflects all prior utilization for such LLP at catalog price, then the use of used parts should not be an issue.  In other words, any LLP reserve reimbursement should deplete the reserves and lessor contribution only to the extent of life remaining on the replacement part.  For example, if a part with 10% life remaining (and for which lessor holds reserves and lessor contributions equal to 90% of the cost of such part) is replaced by a part with 75% remaining (with a cost of 75% of catalog price), then after lessor’s reimbursement (65% of catalog price after netting any waste expense on the replaced part–see more on waste expense below) the lessor should have the benefit of an LLP with 75% life remaining and 25% in reserves/lessor contributions.

Let’s try a more detailed example.  An aircraft is delivered used to the lessee.  One of the LLPs on one of the engines has 60% life remaining at delivery to lessee and the lessor has provided to lessee a lessor contribution equal to 40% of the catalog price for such part.  Lessee pays reserves on such LLP during the term and at the time of removal of such LLP for replacement, 20% life remains on such part; in other words, lessee has paid 40% of catalog price in reserves.  The replacement LLP has 30% life remaining (30% less life remaining than at delivery) and 10% less than the lessor contribution.  Lessor’s reimbursement would be 10% of catalog price after netting any waste expense on the replaced part) and the lessor should have the benefit of an LLP with 30% life remaining and 70% in reserves/lessor contributions.

The key to making these examples work is the assumption that the used LLP is priced on a straight line basis.  And so the conclusion I am drawing from the above thinking is that I can scrap the complicated drafting language I have been using and replace it with something along the lines of the following:  “If the replacement LLP is used then Lessor’s reimbursement obligation will be equal to the lesser of (1) the actual cost of such LLP and (2) the product of (a) the catalog price of such part divided by its cycle life and (b) the number of cycles remaining on such part, in either case, less waste expense.”

Reimbursement on a Part-by-Part Basis vs. from the LLP Reserve Pool

I have discussed this issue in another post and so won’t repeat myself here.  In the leases I have reviewed recently I have seen both approaches taken and also saw a hybrid where the pool approach was used for the LLP reserves and a part-by-part approach was used for the LLP lessor contribution (I didn’t understand the reason behind that split).  My view is that the part-by-part approach is the logical and correct approach because the pool approach shifts operational risk on the LLPs to the lessor.  For a discussion of this issue see this previous post.

Salvage Value, Waste Expense and Stub Life

LLPS are very rarely removed with no life remaining.  Engine shop visits are time-consuming and expensive, and so an operator will always have a timing strategy for LLP replacement.  For example, if an engine is going into the shop for a performance restoration and after the performance restoration the engine will be expected to run without another shop visit for 7,000 cycles, then the operator will generally replace all LLPs on the engine with life remaining of less than 7,000 cycles.  The lease agreement for an aircraft will also usually have an LLP “build standard” for a performance restoration and separately an LLP cycle-remaining return condition, both of which requirements will affect the timing of LLP replacement during a lease term.

The question for the lessor is how to account for the “early removal” of LLPs when collecting and reimbursing reserves.

Some lessors will build the lost cycle life into the reserve rate using a “stub life” assumption–with the effect that the per cycle reserve rate for an LLP is higher than the per cycle catalog price for such LLP.  Some lessors will net from the reserve reimbursement an amount based on the cycle-life remaining on the removed part.  Some lessors will net from the reserve reimbursement the market salvage value (if any) of the removed part, usually in connection with using the stub life approach.

I think the most direct, transparent and easiest-to-explain approach is to base the reserve rate on catalog prices (without adjustment) and then deduct from the reimbursement an amount equal to the product of (1) the per cycle then catalog price of the replaced LLP and (2) the number of cycles remaining on the replaced LLP.  This approach removes the guesswork of stub life and salvage value, with the calculation of LLP reserve rate and reimbursement tied directly to catalog prices.

LLP Replacement–Scope of Reimbursement

LLP reserve reimbursement is for the purchase price of the part, not for repair, installation or any other labor or any other cost.  This preceding sentence isn’t debatable, it’s not an “issue”; it’s the commercial basis of the deal.  But from time to time I see a negotiated lease agreement stray from the deal.  If the lessee wants anything other than LLP price in the reimbursement, then the LLP rate needs to go up.

What Does Life Mean?

I’m just going to touch on this last issue, because it is a big topic.  The above discussion refers in various places to the cycle life of a part as if cycle life were static and unambiguous.  But this not the case.  For example:

  1. Engine manufacturers sometimes extend the cycle life of a part already in service– for example, because operational experience has shown that the part will last longer.
  2. Engine manufacturers may assign different LLP cycle lives to different operators based on each operator’s profile (geographic location, routes, etc.).
  3. Engine manufacturer’s may guarantee a longer life of an LLP than the current cycle life (because the engine manufacturer expects the cycle life will be extended before the current cycle life is used).
  4. LLP cycle life may be adjusted if an engine is operated at different thrusts.

For the lawyer drafting the LLP reserve provisions in a lease agreement, all of the above should be considered while drafting.  I’ll try to come back at a later date for a full discussion of this last issue.  In the meantime, caveat advocatus.


The Definition of “Engine Basic Shop Visit”

I used to joke with a friend that “I’ll be 70 years old and still negotiating the definition of ‘Engine Basic Shop Visit’ on a daily basis.”

That was at least 15 years ago and while “on a daily basis” was an exaggeration, that term (some lessors use “Engine Performance Restoration” or similar terms) is still the most important defined term in most aircraft lease agreements and it is (no doubt about it) the defined term that the lessor’s lawyers and tech officers will look at most often after delivery (and usually while under stress–“oh, please let it say what I need it to say”).

The term should be used sparingly in a lease agreement.  In a previous post I have noted that the term should not be used in return conditions–because the definition usually sets a high standard for the restoration workscope and the main point of the relevant return condition should be on-wing time remaining to the next performance restoration (of any sort)–not on-wing time remaining until the next full performance restoration.  The same logic applies to the delivery conditions, though using the defined term in the delivery conditions would benefit the lessor–unless the delivery conditions uses a “time since” standard for the engine delivery condition.

In lease agreements that I draft the term will usually appear only in the provisions related to maintenance reserves and/or return compensation.  In the maintenance reserve provisions the defined term will be the trigger for when the lessor reimburses reserves.  In the return compensation provisions it will be the trigger for when the hourly return compensation payment from the lessee starts to accrue.  In both cases the lessor will benefit from a high standard.

The definition of ” Engine Basic Shop Visit'” that I use has four components:

1. Workscope. The threshold question in drafting the definition is whether the maintenance reserve/return compensation trigger will be the overhaul of any listed engine module or an overhaul of a set (or all) of modules required.  This issue is usually addressed by the tech and financial officers of the lessor and the resolution will be driven by the expected condition of the engine at delivery and the performance restoration reserve balance for the engine.  (If the “modular approach” is used, then the reserve/return compensation/lessor contribution provisions will need to be drafted to allocate the relevant amounts (usually on a percentage basis) among the modules.)

2. Engine Manufacturer Manuals and Guidelines. The performance restoration should be performed in accordance with the relevant engine manufacturer manuals and guidelines.  The lessor’s tech officers should provide (or at least review) the description of the relevant engine manufacturer manuals and guidelines.

3. Performance Standard. Here is a requirement that I often do not see in lessor’s lease agreements.  The workscope has been agreed with the lessor and the performance restoration has been carried out in accordance with the agreed engine manufacturer manuals and guidelines, but the EGT margin from the test cell after the performance restoration is the same as before the performance restoration.  Should the completion of the performance restoration be a sufficient trigger for purposes of a maintenance reserve reimbursement or return compensation reset?  No, it shouldn’t.

So, I suggest adding a performance standard that requires the performance restoration :

fully restores [the Engine’s/such module’s] performance and service life using the workscope defined in the Engine Manufacturer’s [Engine Management Program and the Engine Manufacturer’s Engine Manual] and so that the EGT margin is (a) at least the average EGT margin that is expected in the industry for an engine of the same model as the Engine fresh from performance restoration (determined on the basis of the Engine Manufacturer prescribed test cell conditions and procedures prevailing at the time of such shop visit) and (b) such that such Engine can reasonably be expected (as determined by the Engine Manufacturer if Lessor and Lessee fail to agree) to run for the average meantime between performance restorations (based on Engine Manufacturer data) for engines of the same model as the Engine

4. LLP Build Standard. The definition should require a minimum LLP build standard, the minimum to be based on the expected run-time between overhauls.  In other words, you don’t want the run-time requirements discussed in 3 above to be undercut by the engine being driven off-wing for an LLP replacement before the next anticipated performance restoration.

Some lessors may argue that 3 and 4 above are unnecessary so long as the lessor has a consent right over the planned workscope.  I don’t think that is right.  A consent right give you no protection over a failed performance restoration and a consent right will likely lead to a negotiation where the lessee will ask for additional (outside of the contract) contributions for what the lessee’s will describe as enhancements to the workscope not required by the lease agreement.  (Nonetheless, somewhere in the lease agreement the lessor should be given consent rights over each performance restoration workscope.)

Random notes:

1. For references to performance restoration where a high standard is not required, I suggest just using “performance restoration” (not defined) or using “Performance Restoration” as a defined term and defining it as follows: “means the off-wing maintenance of an Engine where, as a result of an overhaul or performance restoration, useable life is restored to the engine.”  As always, when using defined terms the drafter and reviewer each needs to be cognizant of both the definition and how it is used–when in doubt, search for the defined term throughout the document and make sure it is being used consistently–and, in each case, to your client’s advantage.

2. In two-way return compensation provisions, you will also need to provide for the “time since” calculation at delivery. As mentioned in a previous post, my preference is (where possible) to specify the date of the last relevant maintenance visit–rather than rely on a definition or description of the prior visit.

Treatment of Engine LLP Reserves in Lease Agreements

Last month I wrote about the most (IMO) overlooked important issue in an aircraft purchase agreement–the description of the aircraft. This post is about the least understood and most neglected (again IMO) section of lease agreements–the maintenance reserve provisions as they relate to engine LLPs.

Some lessors do understand the issues related to engine LLP reserves, and the lease agreements from those lessors reflect that understanding, but for purposes of this post let’s assume we are reviewing a lease agreement with an engine LLP reserve provision that reads as follows (paraphrasing):

Lessee will pay on the 10th of each month with respect to the LLPs on each Engine a maintenance reserve amount of US$200 for each cycle of utilization on such Engine during the previous month.

In the event Lessee replaces LLPs on an Engine during the Lease Term Lessor will reimburse Lessee for the cost of the replacement LLPs from the LLP maintenance reserves paid by Lessee for such Engine.

If an Engine was delivered to the Lessee by the Lessor on the Delivery Date other than with zero time on the LLPs, then to the extent the reimbursement from the LLP maintenance reserves is insufficient to fully reimburse Lessee for the cost of the replacement LLPs Lessor will contribute a further amount up to the product of US$200 and the number of cycles of utilization on the LLPs on the Delivery Date.

Ignoring the imprecise drafting (I did say I was paraphrasing!), how many conceptual errors can you find in the above? Here are the ones I see:

1. First and most importantly, note the above drafting treats the LLPs as a pool. LLPs on an engine may have different manufacturer-mandated cycle-lives and an LLP may fail or be removed before its expected cycle-life. In addition, used LLPs are sometimes installed on an engine as replacement parts. So an engine with 15 LLPs may have 15 different LLP cycle-lives remaining.

If all LLPs stayed installed for their expected life and were always replaced with new LLPs, then treating the LLPs as a pool for maintenance reserves purposes should (I think) work out over time. But if an LLP fails early and needs to be replaced or an LLP needs to be replaced early to comply with an engine overhaul build standard, then under the above drafting a lessee could draw the full cost of the replacement LLP from the reserves and lessor contribution, thereby depleting the reserve pool and lessor contribution out of proportion to the part replaced.

For example, a lessee takes delivery of a used aircraft and operates it for six months, paying US$240,000 in LLP reserves on an engine, before an LLP costing US$400,000 fails. Under the above drafting the lessee could draw the entire US$240,000 plus up to $160,000 of the lessor contribution for the replacement of one LLP.

I can hear some of you saying “what’s wrong with that, the LLP reserve balance is then zero and the lessor contribution is reduced and so the next time the lessee needs to draw for an LLP replacement, it may need to come out of pocket for the cost, right?” Yes, but the problem is that lease terms do not go on forever and at some point the aircraft will need to transition to a new lessee, who will likely be smart enough to ask for a lessor contribution based on its calculation of the cycles used on each LLP; and if the reserves and lessor contributions under the current lease have been depleted through the replacement of a few parts the lessor will need to make up the difference.

To put it another way, treating the LLP maintenance reserves as a pool effectively shifts a lot of the risk of early LLP removal to the lessor. So, the first conceptual error is that LLP reserves and lessor contributions are not tracked on a per part basis.

2. Note that the above drafting does not require the replacement LLP to be new. Replacement of failed or (soon to be) expired LLPs with used LLPs is common practice; there are various legitimate reasons for a lessee to install a used replacement LLP instead of a new LLP. But if a Lessee does install on used LLP there should be limits on the lessor’s reimbursement obligation. For example, let’s say a lessee replaces an LLP with a used LLP that had exactly the same number of cycles as the replaced LLP had on the date the aircraft was delivered to the lessee? Should the lessee be entitled to draw on the LLP reserves allocated to such part? Yes, because the LLP has paid for the time used and is returning the LLP to is original (delivery date) condition. Should the lessee be entitled to make a claim against the lessor contribution for such part? No, because the lessee has not improved the condition of the LLP from its original (delivery date) condition.

As you can imagine there are numerous possible fact patterns to address when dealing with both new and used LLPs and both maintenance reserves and lessor contributions–and the drafting in the lease can get complex–but for purposes of this post just realize that if the lease documentation allows the installation of used LLPs then you need to be very careful how the reserve reimbursement and lessor contribution sections are drafted.

3. Note that the above drafting does not say lessor will reimburse lessee only for the lessee’s net cost of the replacement LLP. The cost of the LLP may be reduced in various ways that won’t be obvious from the invoice that the lessee provides the lessor with the lessee’s reimbursement request. For example, the removed part may have salvage value. Also, the engine manufacturer may have a deal with the airline to provide a credit or rebate in connection with the purchase of LLPs, especially if the LLP comes off early. It may be difficult to determine the lessee’s “true net cost” of an LLP, but at a minimum the lease agreement should contain some general language providing for the netting of salvage value, credits and rebates.

4. The above drafting assumes that the cycle-life of an LLP will not change after installation. If cycle-life is reduced (fortunately a rare occurrence) then the lessor should have the option to adjust upwards the per cycle reserve amount. Of course the lessor may have to concede that the reserve amount be adjusted downwards in the event that cycle-life on one or more of the LLPs is extended.

Finally, I have yet had to deal with this issue but I understand that at least one engine manufacturer is looking at assigning LLP cycle-life on an operator by operator basis–with each operator to be assigned into one of two categories–with some operators being allowed a longer cycle-life and some restricted to a shorter cycle life. The issues here for an operating lessor are obvious and scary, both in the calculation and collection of LLP reserves and the drafting of LLP return conditions. After I gain some real life experience on this issue I will revisit it in a post.

Questions to Ask About a Proposed Engine FHA

Here is a not uncommon situation:  You are a senior officer at an aircraft operating lessor.  One of your lessees has asked whether you would consider waiving engine performance restoration reserves for the remainder of the lease term (and returning the engine performance restoration reserves you now hold) in connection with the lessee entering into a maintenance agreement with the engine manufacturer (or some other third party, but for this discussion let’s assume it is an engine manufacturer).  The lessee tells you that engine manufacturer will agree to perform all performance restorations during the lease term and at the end of the lease term the engine manufacturer will “put the lessor in the same economic position as if the lessor had continued to collect reserves for the remainder of the lease term.”  The lessee then explains that the engine manufacturer will be charging a per flight hour fee for these services pursuant to a Flight Hour Agreement (or FHA) and the lessee does not want to pay both engine performance restoration reserves under your lease and the engine manufacturer’s per flight hour fee.  In addition, the engine manufacturer will be charging an “entry fee” for each engine on your aircraft to reflect utilization on such engine at the time that it enters the engine manufacturer’s program, hence the need for the return of the engine performance restoration reserves you already hold.  Sound familiar?

Let’s say you’re willing to consider this request.  You’ll be losing the use of the cash reserves in your possession and your finance officers have advised you of the cost of that loss.  In addition your legal and credit officers have reminded you that cash reserves are (much) better than a contract right for the same amount.  But you think there are good commercial reasons for considering the lessee’s request–maybe you want to place additional aircraft with this lessee.

Below are the questions that I think you should be asking the lessee and the engine manufacturer about their proposal.  I have provided some rough answers to the first three questions because they are the most important questions.  I will likely return to this topic later and deal with some of the other questions, but the answers to those questions will vary engine manufacturer to engine manufacturer (more so than the first three questions).

1. What happens at the end of the current lease term? At one time the engine manufacturers were willing (at least in my experience) to re-fund the reserve account at the end of the lease term so that the account held the same cash amount as if reserves had continued be paid (and drawn) during the lease term.  Assuming the engine manufacturer (or its relevant subsidiary) is creditworthy and assuming the lessor is willing to absorb the cost of not holding cash reserves during the lease term, this re-funding mechanism really did “put the lessor in the same economic position as if the lessor had continued to collect reserves for the remainder of the lease term.”  My experience lately however is that the engine manufacturers will offer only a “credit” towards a future performance restoration to be performed by one of the engine manufacturer’s shops;  the manufacturer may also agree to “fix” the price of that shop visit.  The calculation of the credit and the fixed price will be based on the engine manufacturer’s own formulae, not the formulae you have used in your lease.  And so in various senses the lessor will not be “in the same economic position as if the lessor had continued to collect reserves for the remainder of the lease term.”

The mechanisms for providing this credit and, if any, fixed price vary from engine manufacturer to engine manufacturer but in general there will be a written agreement between the relevant engine manufacturer and the lessor of the aircraft in which the credit and, if any, fixed price mechanisms are agreed.  I’ll refer to this as the “engine credit agreement.”

2. What impact will these arrangements have if you want to sell the aircraft subject to the current lease–that is, before the end of the current lease term? The buyer of the aircraft will need to review, accept and assume the rights and obligations of the seller under the engine credit agreement.  In most cases, the lack of cash reserves and the need to buy-in to the engine credit agreement is going to have a negative impact on the marketability of the aircraft and the purchase price.  The need to engage with the engine manufacturer during the sale of the aircraft will also complicate, and may delay, the closing of the sale.  (And at least one engine manufacturer requires the buyer to negotiate and enter into its own engine credit agreement de novo, and not simply take an assignment of the seller’s engine credit agreement (which the seller is prohibited from showing to the buyer).)

3. What impact will these arrangements have on the re-lease of the aircraft to a new lessee at the end of the current lease term? In a typical lease transition the new lessee will look to the lessor to provide maintenance credits reflecting the utilization of the aircraft on the delivery date to the new lessee–so that when the new lessee performs maintenance on the aircraft it may draw cash from the lessor to pay for such maintenance.  But where you as lessor have agreed to an engine credit agreement in connection with the current lease, all you will be able to offer the next lessee is a credit (or as a former colleague of mine called it, a “gift certificate”) for use in connection with a performance restoration performed by the engine manufacturer.  The new lessee is going to have various concerns here:

(a)  The new lessee will be required to have its engine performance restoration done by the engine manufacturer if it wants to use the credit;  that is, the new lessee cannot “shop around.”

(b)  The new lessee will be required to pay the fixed price agreed by the lessor–or, if there is no agreed fixed price, the new lessee will be subject to whatever the engine manufacturer charges at the time.

(c)  The workscope and other relevant terms of the performance restoration (see 8 below) will likely be agreed in the engine credit agreement and not open for negotiation by the new lessee.

The effect of the above is that a potential next lessee will look elsewhere for its aircraft needs or, more likely, will look to the lessor to fill any gaps with additional maintenance credits and/or rent concessions and/or other commercial concessions.

4. What happens if the current operator defaults in its obligations under the FHA or terminates its obligations under the FHA?

5. What is the workscope for the engine performance restorations to be performed under the FHA? And will the performance restorations under the FHA during the current lease term (a) meet the requirements for performance restorations under your lease agreement, (b) allow the current lessee to meet its return requirements and (c) result in the engines being in the same or better condition at return (than without he FHA)?

6. What is the expected cost of the “fixed cost” engine performance restoration? How does that cost adjust based on utilization and inflation and other factors?  Is there a per annum assumed floor for inflation (that is, even if inflation is zero in any one year does the cost will still increase by a minimum stated percentage)?  What if the market price charged by the engine manufacturer (or other engine overhaul shops) for a performance restoration at the time of your performance restoration is less (maybe way less) than the fixed price?  Are there exceptions (e.g., FOD) to the fixed cost where the new lessee loses the benefit of the fixed cost agreement?

7. What is the workscope for the engine performance restoration to be performed under the engine credit agreement? Does the engine credit agreement allow for the workscope to be modified, and with any fixed price to be as adjusted?

8. What are the other terms for the engine performance restoration? Keep in mind here that you’re essentially contracting for an engine performance restoration possibly 10 to 15 years (or longer) from signing.  All the terms that you would normally negotiate in an engine performance restoration agreement (workscope, performance criteria, warranties, turn time, etc.) should be addressed in the engine credit agreement.

9. What happens if there is an engine total loss (either as part of an aircraft total loss or where only the engine is lost) during the current lease term? Does the accrued credit transfer to the replacement engine or get paid to the lessor in cash?

10. What happens if there is an engine total loss (either as part of an aircraft total loss or where only the engine is lost) after the current lease term but before the performance restoration is performed under the engine credit agreement? Is the credit lost?  Or does the lessor get the equivalent of the credit in cash?

11. What if during the current lease term you want to swap an engine subject to the engine credit agreement to another airframe in your fleet at the same operator–or at a different operator?

12. What if during the current lease term you want to sell an engine subject to the engine credit agreement in connection with an engine swap with the current operator?

13. Do the FHA and engine credit agreement effectively prohibit subleasing of the aircraft by the current lessee?

14. Is the engine manufacturer’s consent or cooperation required in connection with any early termination or extension of the lease term for the aircraft?

My guess is that you have thought of additional questions as you have read the above.  The above list of questions is not exhaustive.  Feel free to send me an email if you think I should add other questions to the above list.

Dealing with Maintenance Reserves in the Novation Agreement

Buying used commercial aircraft where the aircraft is on lease to an airline is often seen by the transaction participants (buyer, seller and (if any) lender) as a straightforward and simple transaction.  The buyer and seller agree the purchase price for the aircraft and then get the cooperation of the lessee to the transfer of the lease and, voila, the deal is done.  Aircraft finance lawyers know it’s not quite that simple, but compared to other aircraft transactions, aircraft sales are definitely on the lower end of complexity spectrum.

Aircraft sales and lease transfers do however have many traps for the unwary and one of the biggest traps involves the transfer of the aircraft maintenance reserve balances and responsibilities from the seller to the buyer.  Both the buyer and seller of the aircraft are well aware that the reserves balances need to be transferred as part of the aircraft sale, and the commercial and finance officers on both sides will spend time agreeing between themselves the reserve balances at the time of the closing.  The transfer of the reserves at the closing usually is usually accomplished by netting the agreed amount from the purchase price paid by the buyer.

Sometimes overlooked in these transactions are one or more of the following matters between the buyer–as the new lessor–and the lessee. All of these matters should be addressed in the lease novation (or assignment).  A misunderstanding between the new lessor and the lessee on any one of these issues could lead to a very expensive and acrimonious argument.

1. The new lessor and the lessee should agree the per-hour/cycle/month reserves amounts in effect on the date of closing. These amounts are usually stated as base amounts in the lease documentation and are subject to adjustment for escalation/inflation and for variations from assumptions regarding hour-to-cycle ratio, minimum utilization and other similar operational measurements.

2.  The new lessor should also check to make sure these adjustments (often done on annual basis) have been done in accordance with the lease documentation and on a timely basis throughout the current lease term. At a minimum the new lessor should ask the lessee to confirm in the lease novation that the lessee will not, after the purchase, request a retroactive adjustment because the previous lessor had skipped, missed or made a mistake in a prior adjustment.  Keep in mind that the reserve adjustment provisions in some lease agreements provide for retroactive credits to the lessee, and the new lessor does not want to get an unexpected reimbursement request after the purchase closes.

3. The new lessor and lessee should agree the individual reserve balances as of the last day of the month before the closing. It is common for the lessee and lessor to disagree over these amounts, often because one or the other or both have made simple bookkeeping mistakes along the way or used slightly different methodologies.

4. Where the aircraft delivered to the lessee was not new the lessor will usually have agreed in the lease agreement to provide maintenance credits (aka lessor contributions) to the lessee to reflect utilization since new or since last overhaul at the time of delivery. These lease agreement provisions are, unfortunately, often loosely drafted and when that happens these provisions give rise to high-dollar value arguments between the new lessor and the lessee.  In a perfect world the original lease agreement should provide actual dollar amounts for each of the credits, but in many (maybe most) cases the lease agreement will say something like (paraphrasing) “to the extent the reserves are not sufficient to cover the cost of the first relevant maintenance visit lessor will contribute an amount up to the product of (1) the relevant reserve rate and (2) the number of hours/cycles/months (as relevant) at delivery since the last such maintenance visit.”  If so, the issues will be as follows:

(a)  Is the reserve rate the base reserve rate–or is it the rate as escalated and otherwise adjusted through the date of the maintenance?  While the per hour/cycle/month difference in the dollar amounts may be very small, the aggregate amount can easily be hundreds of thousands of dollars.

(b)  When was the last “relevant maintenance visit”?  In other words, what is the starting date for the calculation?  Sometimes this date is hard to determine, especially with engines and APUs and even with airframes where the airframe manufacturer has changed the interval and/or scope of the relevant check during the lease term.

So, unless the lease agreement is crystal clear on these issues, in the lease novation the new lessor should agree with the lessee either the actual dollar amounts of the maintenance credits or at least the relevant per hour/cycle/month credit amounts and the date of the “last relevant maintenance” for each credit.

Also, the new lessor and the lessee should agree in the lease novation which maintenance credits have already been satisfied by the selling lessor.  For the most part this last issue should be non-controversial.  The exception may be for maintenance credits for engine LLPs, for which lessors have lots of different approaches as to how they collect and reimburse reserves and apply maintenance credits.  I’ll write more about engine LLPs at another time.  In the meantime, tread carefully.

(Whether, when and to what extent the seller transfers the remaining maintenance credits to the buyer is a separate topic for discussion later.)

5. The new lessor should have the lessee confirm that, at the time of the purchase closing, the lessee has not performed any reimbursable maintenance for which the lessee has not been reimbursed–or if that is not correct, then the relevant maintenance and (if possible) the reimbursement amount should be specified in the novation. The buyer/new lessor has based its purchase price in part on the maintenance condition of the aircraft and the reserve balances.  It will be a very unpleasant shock to the new lessor to learn that it has to reimburse the lessee for maintenance for which the new lessor had thought the lessee had already been reimbursed.

The above is more than I intended to write, but this is a complex topic and there is more to say.  I’ll come back to this topic at a later date and talk about, inter alia, engine LLPs, the transfer of maintenance credits and the transfer of leases where return compensation (instead of maintenance reserves) is payable.