In the early 1990s, airlines primarily relied on two types of aircraft to transport their passengers: (1) small turboprops and (2) single-aisle 100-seat jets. Seeking to exploit a potential gap in the market, Bombardier and Embraer introduced a new 50-seat regional jet to the airline industry. Aside from providing significant fuel savings and creating new opportunities to provide service to smaller destinations, the regional jet enabled major U.S. airlines to take advantage of the “scope clause” contained in their contracts with pilot unions. By having only 50 seats, these new regional jets were exempted from union contracts, which permitted the airlines to subcontract their operation to regional airlines that had much lower labor costs. These benefits caused regional jet manufacturing to boom—to date, Bombardier and Embraer have delivered more than 1,000 of their respective regional jets to their customers.

History of Residual Value Guarantees

In order to facilitate the sale of regional jets, manufacturers offered residual value guarantees (RVGs) to airlines and investors. In these RVGs, the manufacturer provided the airline or the investor in the aircraft with a specific guaranteed value at the end of the lease or loan term. If, at the end of the term, the fair market value of the aircraft was below the guaranteed amount, the manufacturer was required to pay the difference as long as the conditions to payment under the relevant RVG were satisfied. Many of the underlying loans and leases for these original RVGs are now expiring, and the manufacturers are looking at potentially significant liabilities. As of December 31, 2018, Bombardier’s maximum exposure for its RVGs was $695 million, and as of December 31, 2017, Embraer had potential exposure of $375.1 million. Under the RVG, the owner of the aircraft and the manufacturer are meant to work together in the return process to maximize the value of these aircraft; however, in today’s market, the secondary trading and part-out market for regional jets has diminished, so the owners of these aircraft are relying on RVGs to recoup their investments. Due to the fact that the aircraft owners and manufacturer’s interests can be directly opposed to one another, a very complicated and contentious process can result.

Embraer S.A. v. Dougherty Air Trustee, LLC

In a recent case, Embraer S.A. v. Dougherty Air Trustee, LLC,5 Embraer argued that it should not be required to make any residual value payment to Dougherty Air Trustee, LLC (Dougherty), the owner of the aircraft. As discussed below, Embraer prevailed at the New York Southern District Court, and this case should serve as an important reminder to owners, lessors and other investors that they need to constantly refer to the specific terms in their own RVG to ensure that they comply fully with the requirements of the RVG.

Background of the Case

In this case, Embraer sold a new aircraft that was leased to Shuttle America Corporation (Shuttle) pursuant to a leasing agreement dated May 18, 2000 (the Shuttle Lease). The Shuttle Lease expired on November 18, 2016. Simultaneously with execution of the Shuttle Lease, Embraer entered into an RVG that guaranteed the aircraft’s market value at the expiration of the Shuttle Lease. As is customary with RVG contracts, this RVG provided for certain “Termination Event[s]” under which Embraer would be released from its obligation to pay any amount. One of these Termination Events was the termination of the Shuttle Lease prior to its expiration date. However, the RVG could be revived if “a replacement lease on substantially the same maintenance, assignment, and return terms and conditions as the [Shuttle Lease]” was entered into.

In February 2016, Shuttle filed for bankruptcy, and in April 2016, the bankruptcy court entered an order rejecting the Shuttle Lease. As part of the bankruptcy proceedings, Shuttle returned the aircraft to Dougherty; and Dougherty was awarded approximately $1.95 million as settlement for the rejected Shuttle Lease. After Shuttle’s bankruptcy, Dougherty entered into a new lease with Coleman Jet, LLC (Coleman) to try to revive the RVG. As part of the lease (the Coleman Lease), Coleman entered into an assumption agreement pursuant to which it agreed to “assume all obligations of [Shuttle] under the RVG.” Dougherty sent a copy of the assumption agreement to Embraer and asked Embraer to execute, but Embraer never executed it. In order to satisfy the return conditions under the RVG, Dougherty sent the aircraft in for maintenance but ran into issues regarding the extent of needed repairs. Eventually Dougherty was able to complete the restoration maintenance, and it informed Embraer that the aircraft was ready for inspection. However, Embraer never performed any such inspection. After not receiving any cooperation from Embraer, Dougherty sold the aircraft to a third party and demanded payment under the RVG from Embraer. Embraer rejected the claim and filed the declaratory judgment action described in this case.

Embraer argued that (1) Dougherty was estopped from claiming any payment under the RVG, since it had already done so in addition to recovering in connection with the Shuttle bankruptcy, (2) the Coleman Lease did not satisfy the requirements of a “Replacement Lease” under the RVG and (3) Coleman did not satisfy the requirements of a “Replacement Lessee” under the RVG. Embraer prevailed on all three arguments, and the court granted summary judgment in favor of Embraer.

In defense of Embraer’s first argument, Dougherty asserted that even though it had agreed to settle its claims with Shuttle, it did not waive its rights to make claims against third parties, including Embraer. Even though the $1.95 million settlement it received from Shuttle was $585,000 less than the payment it would have been entitled to receive under the RVG, the court deemed this to be a compromise made by Dougherty, and it estopped Dougherty from trying to sue Embraer for RVG payment. This decision highlights the fact that aircraft owners and investors must be mindful that any settlement discussions relating to an aircraft, whether involving the manufacturer or not, can have a potential impact on their investments.

On Embraer’s second argument, the court used the definition of a lease under New York contract law, since “lease” was not defined within the RVG. The failure to define the term “lease” gave the court the ability to analyze the substance of the Coleman Lease in detail. The court found that since Coleman was paying $0 in rent each month until the aircraft became airworthy, the contract failed due to a lack of consideration. Despite the defendant’s argument that Coleman promised to pay rent in the future, the court found that the “Coleman Lease was little more than a sham document which Dougherty hoped would help it recover under the RVG.”

Finally, the court’s analysis of whether Coleman met the requirements of a “Replacement Lessee” under the RVG came down to the court’s interpretation of “Expiration Date” in the RVG. At the time the parties entered into the Coleman Lease, Coleman was not authorized to operate the aircraft, but Dougherty’s position was that after the completion of certain maintenance on the aircraft, Coleman would have been able to obtain the necessary approvals from the Federal Aviation Administration (the FAA) to get the aircraft added to Coleman’s operating certificate. In one section of the RVG, the term of the RVG could be extended for up to 150-180 days in order to comply with the various return requirements. Dougherty argued that this 150- to 180-day extension period should also apply to the requirement for Coleman to have authorization under all applicable laws to operate the aircraft. The court rejected this argument and held that the original expiration date of November 18, 2016 applied, even though it was tied to the non-existent Shuttle Lease. The court then concluded that it would not have been possible for the necessary maintenance to be completed in time for Coleman to become authorized by the FAA. Since Coleman did not satisfy the requirements of a “Replacement Lessee” by November 18, 2016, the RVG was not revived, and Dougherty had no right to claim payment under the RVG.

Conclusion

Owners of and investors in regional aircraft that are subject to RVGs and are approaching their lease or loan maturity dates need to be diligent in their approach to the maintenance and redelivery options as these aircraft near lease maturity. Most of the RVG contracts were drafted over a decade ago and, as highlighted in this case, can contain very complicated, and sometimes subjective, wording laying out the conditions that must be satisfied before a manufacturer is actually obligated to pay. The specific terms in a RVG may be highly particularized for a specific owner or operator, but each RVG will generally contain requirements on the redelivery conditions, timing deadlines and manufacturer input. It is imperative that each owner and/or investor study these provisions and involve the manufacturer as early as possible in the return process in order to ensure a positive result.