Aircraft Lease Terms Legal Definitions – IFRS 16 – Lessee’s Covenants, Cape Town Convention, Quiet Enjoyment

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How will IFRS 16 Leases Affect Aviation Companies?

Leases previously treated as operating leases will generally now be an on-balance sheet.

A lessee will recognise a right-of-use asset and a lease liability, and consequently depreciation and interest expense in profit or loss.

The new Standard, in addition to bringing substantial new assets and liabilities onto airlines’ balance sheets, will have an impact on reported profit and performance measures such as return on capital employed (ROCS).

The impact on individual Lessors will depend on their particular financing and leasing structures.

The limited recognition exemptions permitted are unlikely to be of much relevance for airlines, given they relate to leases with a lease term of 12 months or less and leases of underlying assets which have a low value when new.

IFRS 16 sets out a comprehensive model for the identification of lease arrangements and their treatment in the financial statements of both lessees and lessors.

One of the most notable aspects of IFRS 16 is that the lessee and lessor accounting models are asymmetrical.

For lessees, IFRS 16 introduces a single accounting treatment, recognition of a right-of-use asset and a lease liability.

For lessors, the current finance and operating lease distinction and accounting remains largely unchanged.

Aviation Lease Additional Notes IFRS 16

For lessees with operating leases, an ‘aircraft’ (right-of-use) asset will come on the balance sheet together with a lease liability.

Significant KPIs including ROCE (Return on capital employed) will be affected – for some it will increase, for others decrease.

For foreign currency leases, there will be increased profit and loss volatility as the lease liability is retranslated.

For a ‘wet’ lease only payments for the aircraft need to be recognised, the service element may be separated with the accounting unchanged.

Lessee’s Covenants

Lessee shall perform and comply with its undertakings and covenants in the Lease at all times during the Term. All such undertakings and covenants shall, except where expressly otherwise stated, be performed at the expense of Lessee.

Example of Covenants – Lessee will:

a) provide Lessor with a Technical Report for the Aircraft within seven (7) days after the end of each calendar month throughout the Term;

b) provide Lessor with, or electronic access to, the Financial Information;

c) promptly after the occurrence thereof (and in any event within seven (7) days thereof)

d) notify Lessor of any Event of Loss or of any event which Lessee (acting reasonably and in good faith) believes is likely to result in an insurance claim in excess of the Damage Notification Threshold

and

e) upon Lessor’s reasonable request, details of any negotiations with insurers or insurance brokers relating to such claim;

f) promptly after the occurrence thereof, notify Lessor of any Event of Default which has not been cured and, on Lessor’s request, provide (not more frequently than annually) a certificate signed by its chief financial officer that there is no Event of Default under the Lease or the Transaction Agreements or if any such Event of Default, shall exist, specifying the same;

g) provide Lessor, upon request, with evidence that all Taxes (other than Taxes subject to Section 5.7(c)) and charges that are due and payable and were incurred by Lessee in connection with the Aircraft, its location and its operations, including those invoiced by airports and air traffic control authorities, have been paid in full (or are being contested in good faith by appropriate proceedings in respect of which adequate reserves have been provided by Lessee and non-payment of which does not give rise to any risk of the Aircraft or any interest therein being sold, forfeited or otherwise lost or of criminal liability on the part of Lessor or Owner);

h) provide Lessor with such other information concerning the location, condition, use and operation of the Aircraft or concerning the business or financial affairs of Lessee, as Lessor may from time to time reasonably request;

i) give Lessor not less than sixty (60) days prior written notice as to the time and location of all Major Checks; and

j) notify Lessor, promptly, of the removal of any Engine for the purpose of Engine Refurbishment.

Quiet Enjoyment

Quiet enjoyment is the right of the lessee to possess, use and operate the aircraft without any interference from the lessor or the creditors of the lessor—so long as the lessee has not defaulted on its obligations.

The lessee’s quiet enjoyment rights against parties other than the lessor are not automatic and may need to be bargained for:

for example, a lender to a lessor would prefer that the lessee not have any quiet enjoyment right against the lender so that, after a default by the lessor, the lender could recover the aircraft and sell or otherwise dispose of it “free and clear” of the lessee’s rights.

Any such act of interference constitutes a breach of the right to quiet possession, whether it takes the form of physical seizure, disablement of the aircraft object, restriction of access to it or otherwise.

Lessees want the covenant to apply in the absence of an “Event of Default” under the lease, so quiet enjoyment will not be impaired during any grace period for defaults under the lease.

Where the lessor has borrowed money and secured the loan by granting a security interest in the lease, the lessee usually expects a similar quiet enjoyment covenant from the lessor’s lender, although sometimes this is a negotiated issue.

Cape Town Convention

The Cape Town Convention is designed to create an international framework for the formation, registration (through an International Registry), protection and enforcement of certain international interests in airframes, aircraft engines and helicopters.

Cape Town Convention Advantages to Aircraft Financiers

For an aircraft financier, the merits of the Cape Town Convention and its Aircraft Equipment Protocol (together Cape Town) are that it aims to:

a) Protect the parties’ title and security interests in aircraft and engines by:

i/ Providing for the registration of international interests at a single, web-based International Registry that is always open

ii/ Subjecting those interests to a simple priority regime whose main principles are:

1/ Registered interests take priority over unregistered interests;

2/ Earlier registrations take priority over later registrations; and

3/ The parties can vary priorities by registering subordination arrangements at the International Registry.

b) Bring speed, certainty and cost savings to the process of repossessing (and otherwise realising value from) aircraft and engines on insolvency or other default, particularly where these assets are in a country whose legal system would otherwise give cause for concern in such matters.

Cape Town Convention Advantages to Airlines

The intention of Cape Town is that the benefits for financiers will result in reduced Finance costs to airlines.

For example – US Eximbank offers a discount on its exposure fee on financings into Cape Town states.

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