Introduction

Brazil's airlines are facing unprecedented economic and financial pressures. Political scandals have rocked the government and the president is facing impeachment proceedings. During 2015 the Brazilian real lost over 45% of its value compared to the US dollar and the economy shrunk by approximately 3%. The economic situation has not improved during the first quarter of 2016, and current projections are that Brazil's economy will not improve until the last quarter of 2017 or perhaps as late as 2018. Against this background, demand for passenger air services has dropped severely, as the purchasing power of Brazilian consumers is at its lowest point in the last 10 to 15 years.

With approximately 15 to 20% of their payment obligations fixed in US dollars, Brazil's airlines have seen their operational profits drastically decline and are experiencing significant operating losses. Although no airline has sought bankruptcy protection, the risk that a major Brazilian airline will seek such protection is considerable and lessors should be aware of their rights and risks if an airline were to file for bankruptcy.

Bankruptcy procedure

Brazil has a procedure roughly similar to Chapter 11 in the US Bankruptcy Code called 'judicial recuperation'. The Bankruptcy Law which introduced judicial recuperation came into force in 2005. Before 2005, airlines were prohibited from seeking bankruptcy protection from creditors. Therefore, there is no Brazilian precedent of airline bankruptcies before 2005.

The airline Varig filed for judicial recuperation two weeks after the Bankruptcy Law came into force. Consequently, there was a considerable lack of knowledge about how the law should be applied – in particular, Article 199 of the law applies solely to aircraft and aircraft engine leases. Article 199 is similar to Section 1110 of the US Bankruptcy Code in the sense that it is particular to aircraft leases; however, Article 199 is shorter and simpler than Section 1110. Article 199 stipulates that rights under leases of aircraft and aircraft engines are not suspended during any judicial recuperation procedure. In other words, an airline in judicial recuperation does not have protection from its aircraft lessors. While creditors may be stayed from suing the airline, aircraft lessors cannot.

Since the Bankruptcy Law came into force, five different airlines have sought judicial recuperation protection: Varig, VASP, BRA Airlines, VarigLog (which was unrelated to Varig when it filed) and Passaredo (a small regional carrier). Of these, Passaredo is the only airline operating today.

In the original version of the Bankruptcy Law, Article 199 contained some ambiguous language that enabled Varig to argue that the special protections afforded to lessors applied to finance leases but not to operating leases. At that time, Varig's fleet was comprised of around 85 aircraft on operating leases and 40 on finance leases. Thus, for around six months Varig avoided the protections provided to lessors in Article 199. In November 2005 Congress amended the ambiguous language in Article 199 to clarify that all leases – both operating and finance leases – are covered by Article 199. This position was confirmed in the subsequent bankruptcy proceedings of BRA Airlines, VarigLog and Passaredo.

The Cape Town Convention is now effective in Brazil. Although, according to the terms of the convention, the effective date in Brazil should have been March 1 2012, the Brazilian implementing laws and subsequent regulations established May 15 2013 as the effective date. It is highly advisable that lessors determine which of their leases are covered by the Cape Town Convention. In most cases, this can be ascertained by reference to the contract dates and delivery dates.

In relation to insolvency proceedings under the Cape Town Convention, Brazil adopted what is commonly referred to as 'Alternative A', which contains rules similar to those set out in Section 1110 of the US Bankruptcy Code. This means that an airline with bankruptcy protection is granted a stay period during which lessors are prohibited from repossessing their aircraft. After expiry of that stay period, the airline must either address events of default or return the aircraft. In Brazil, the stay period under the legislation implementing the convention is 30 days (half the period applicable in the United States). To date, Alternative A has not been tested in Brazil and there have been only a few cases worldwide, mainly in India and Russia.

Repossession rights in judicial recuperation

If an airline were to seek judicial recuperation, the court would apply Alternative A to the leases of aircraft delivered after May 15 2013 and Article 199 to leased aircraft delivered before that date. However, it is uncertain whether the bankruptcy courts will apply two different sets of rules. It is conceivable that a court might apply the Cape Town rules to the entire fleet, especially if the airline and lessors do not object.

For aircraft covered under the convention, the airline has a 30-day stay period. After that time, the airline must pay any outstanding defaults or return the aircraft. The bankruptcy court should order the airline to return the aircraft.

For aircraft that are not covered by the convention, lessors can sue the airline for repossession at any time (provided that some event of default with regard to the lease has occurred). There is no need to wait 30 days.

To date, there have been no tests of whether a default event is triggered by the mere filing of an application for bankruptcy/judicial recuperation protection (the so-called 'ipso facto' event of default). Similar to the position in New York, it is questionable whether such an event of default could, by itself, constitute grounds to seek repossession of a leased aircraft. In most cases, payment for an event of default occurs together with the ipso facto default and thus this issue does not arise.

One procedural difference between aircraft falling under the Cape Town Convention and those under Article 199 is that the bankruptcy courts will not necessarily order repossession of aircraft falling under Article 199. The lessors of those aircraft may have to sue the airline for repossession. Moreover, those suits would not necessarily be filed in the bankruptcy court. Under Article 199, an aircraft lessor must sue a lessee as though the bankruptcy proceedings did not exist. The usual venue for a repossession case is a civil court, not a bankruptcy court.

Deregistration with IDERAs

With the advent of the Cape Town Convention – in particular, the Aircraft Protocol – the use of irrevocable deregistration and export authorisations (IDERAs) became possible. In 2014 the Brazilian Civil Aviation Agency promulgated regulations concerning the use of IDERAs. Provided that an IDERA has been registered with the Brazilian Aeronautical Registry, the party named as the authorised party therein can request deregistration and the registry will (according to the regulations) respond to the request within five business days. The regulations require the authorised party to notify all interested parties, which is generally understood to mean the airline and any registered mortgagee.

In 2014 three aircraft were deregistered from the registry using IDERAs. Each of those deregistrations occurred within the five-day limit. The lessees of those aircraft did not challenge the deregistrations. Since 2014 no attempts to use IDERAs have been filed with the registry.

Claims

The Cape Town Convention does not apply to claims. As such, the Bankruptcy Law applies to all claims against airlines in judicial recuperation, even if repossession remedies are governed by the convention. The approach set out in Article 199 of the Bankruptcy Law regarding aircraft lessor claims is similar to that in relation to repossession – that is, claims due under aircraft leases are excluded from judicial recuperation proceedings.

A debtor in judicial recuperation must present a debt restructuring plan to its creditors and obtain the creditors' approval within 150 days of its application for judicial recuperation protection. Debt restructuring plans usually provide for repayment of accumulated debt over long periods of time at low interest rates. The plans also include long grace periods and sometimes incorporate principal reductions (ie, haircuts).

However, aircraft lease debt is excluded from debt restructuring plans. This means that an airline cannot force its lessors to subject their claims to any debt restructure. In the judicial recuperation proceeding involving BRA Airlines, the airline attempted to subject its lessors to a debt restructuring plan by arguing that once the leased aircraft were returned, the remaining debt became regular unsecured debt subject to rescheduling. The court rejected BRA's argument and held that lease debt remains privileged and outside the protection of the Bankruptcy Law.

Airlines that have undergone the judicial recuperation process have included options for aircraft lessors voluntarily to subject their debts to a debt restructuring plan, even though such lessors must accept any such offer. An aircraft (or engine) lessor could sue an airline under a lease without regard to the judicial recuperation procedure. The airline would not be protected by a stay against such suits. Although this places aircraft lessors in a privileged position with regard to other creditors, the practical value of this privilege has not helped aircraft lessors obtain better recoveries from the Brazilian airlines that have undergone judicial recuperation. As none of those airlines had many or any assets to satisfy claims, the aircraft lessors ultimately received no significant payments in respect of their claims.

Comment

Generally, the rights of aircraft and engine lessors are well protected in relation to both repossession rights and claims. Depending on when leases were concluded, repossession rights may be governed by the Bankruptcy Law or the Cape Town Convention, as implemented in Brazil. Although there are procedural differences between the two, lessors' rights to secure and retake their leased assets are strong. Lessors' rights in relation to claims are also strong; however, this does not always result in meaningful recoveries.

Brazil's airlines will likely seek judicial recuperation protection only if they have no alternative. Today's airlines are aware that predecessors which used the judicial recuperation procedure have not survived (Passaredo still survives, but barely). In Brazil, lenders have not shown enough confidence to provide debtor-in-possession financing to airlines in judicial recuperation. Thus, the chances of survival, while not impossible, are probably lower than in the United States. In addition, airlines are expected to cooperate with lessors in relation to the redelivery of aircraft. Operators in Brazil and elsewhere that have tried to hold aircraft hostage in bankruptcy proceedings have not fared well, and any withholding will prejudice their ability to lease in aircraft when the economy improves. There is little doubt that the Brazilian economy will improve and, due to its size, dynamism and geographic scope, the demand for commercial aircraft will again increase. The challenge is to stay in business during the severe cyclical downturn that is being faced.

For further information on this topic please contact Kenneth D Basch at Basch & Rameh by telephone (+55 11 3064 8599) or email (ken.basch@baschrameh.com.br). The Basch & Rameh website can be accessed at www.baschrameh.com.br.

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