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21 March 2018
Approach one – side letter and lease back approach
Approach two – split effective time approach
The inclusion of engine pooling arrangements and rigorous maintenance requirements in operating leases frequently results in engines which formed part of a leased aircraft at delivery (ie, the original aircraft) being off-wing. Off-wing engines create complications for transaction parties attempting to execute a sale of the aircraft. While these complications are not insurmountable, the marketplace has developed different approaches to address the off-wing engine scenario. This update explores the issue, the related approaches and the attendant risks to transaction parties.
The successful conclusion of a sale and purchase transaction may be put in jeopardy if one or both of the original engines is off-wing at the time of closing, as it may not be possible for the purchaser to acquire title to the airframe and the original engines simultaneously.
In cases where each object is located in a tax-friendly location at the intended closing time (ie, the closing location), an all-in-one closing may still be possible. However, the more common scenario is where each object forming part of the original aircraft arrives at its closing location at different times, leading the parties to an impasse in which the documentation does not provide for a mechanism to resolve such a closing conundrum.
Further, the age, utilisation rates, condition and maintenance records of the original engines will have formed part of the original aircraft's overall valuation at the transaction's pricing stage. If in the lead up to closing it transpires that one or both of the original engines are off-wing and in a jurisdiction that is unsuitable for a closing of the intended sale transaction, the parties would need to consider alternative approaches. Some of these will necessitate revisiting their pricing calculations at a frustratingly late stage in the transaction.
The purpose of the split closing mechanism is to allow the transacting parties to navigate through the issues caused by off-wing engines without compromising the lessee's flight schedules or the purchaser's funding arrangements. The mechanism effectively entails a series of title transfers by way of a corresponding number of bills of sale for the relevant airframe and each engine. Each title transfer takes place sequentially as and when the airframe and engines forming part of the original aircraft arrive at their respective closing locations. By the end of the process, the purchaser should have up to three (or five, depending on the aircraft type) released bills of sale which, when collated, would effectively evidence the transfer of title to the entire original aircraft.
Using the example of an airframe and one original on-wing engine (the airframe and on-wing engine) and one off-wing engine arriving at their separate closing locations at different times, this update describes two commonly used methods of documenting a split closing.
Under this approach, the seller and purchaser enter into a sale and purchase agreement side letter (intentionally leaving the lessee, the novation and the effective time notice out of the equation). The side letter would exhibit a short-form lease agreement, a split bill of sale and a return bill of sale and would document the following sequence of events:
The benefit to the transaction parties of using the side letter and leaseback approach is twofold:
One disadvantage is that because the new insurance documentation may not have been issued (as conditions precedent do not need to be satisfied until step three above), it may be the case that the purchaser will not be insured for third-party liability during the period of ownership of the airframe and on-wing engine and the leasing thereof back to the seller under the lease. In such an instance, the purchaser may wish to:
The principle distinction between this approach and approach one is that where the latter relies on a side letter to the sale and purchase agreement between the seller and the purchaser (leaving the lessee, the novation and the effective notice at bay until step three above), this approach focuses on the novation and splitting the effective time notice itself. Typically, the novation would contain a provision envisaging a split closing pursuant to which the parties agree to have all conditions precedent (including payment and receipt of the purchase price) satisfied in advance of the arrival of the airframe and on-wing engine at its closing location (and the release of the effective time notice for the airframe and on-wing engine).
To satisfy the payment condition precedent, the purchaser would pay the entire purchase price pursuant to a refund undertaking given by the seller. This undertaking would entitle the purchaser to an immediate refund of the purchase price in the event that the transaction fails to close as a result of, for example, the off-wing engine failing to reach its closing location within a pre-agreed timeframe.
A well-drafted split-closing clause in a novation would document that following the transfer of title to the airframe and on-wing engine from the seller to the purchaser and the release of the effective time notice for the airframe and on-wing engine, the lease will be deemed to have been novated only with respect to the airframe and on-wing engine. It would also provide that until such time as the off-wing engine arrives at its closing location, it will remain subject to the existing lease with the seller or existing lessor as its continuing lease counterparty. To avoid any unintended consequences that may arise out of a prolonged split-leasing arrangement for the airframe and on-wing engine and off-wing engine, prudent parties would agree that they may commence the closing process only once they are fully satisfied that both objects will arrive at their respective closing locations within 24 hours.
On the seller's receipt of the full amount of the purchase price and following the arrival of the airframe and on-wing engine at its closing location, the first effective time notice (the face of which would refer only to the airframe and on-wing engine) would be released. The parties would then wait for the off-wing engine to reach its destination, following which the second and final effective time notice (the face of which would refer only to the off-wing engine) would also be released, resulting in the purchaser becoming the owner and new lessor of the entire original aircraft.
The upside to approach two is that it is less document intensive than approach one, as the procedure is covered by the novation itself, without the need for a separate side letter, lease and return bill of sale. The downside is that the purchaser needs to pay the full amount of the purchase price before delivery of the first object, although the risks arising from this can be mitigated with a well-drafted refund undertaking.
Assuming that a split closing is desirable or necessary, the transacting parties should familiarise themselves with the risks and ramifications inherent in the process by working closely with legal and tax advisers. There are pitfalls in both methods described in this update and the parties should be sure to document their intentions carefully (irrespective of which approach they opt for) so as not to create any unintended consequences.
Ultimately, the choice of approach for conducting the closing will depend on a number of factors including, for example, the sophistication and cooperation of the lessee. If the lessee is defensive and uncooperative with regard to the process (something that parties normally obtain a sense of early in the negotiation), approach one may be the better choice. However, if all parties are experienced in aircraft sale transactions, approach two could lead to a smoother outcome.
For further information on this topic please contact Lev Gantly at Vedder Price LLP by telephone (+44 20 3440 4680) or email (firstname.lastname@example.org). The Vedder Price website can be accessed at www.vedderprice.com.
The materials contained on this website are for general information purposes only and are subject to the disclaimer.
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