Introduction

British Airways (BA)/Iberia, BA/American Airlines - two proposed mergers involving international “flag carrier” airlines with others potentially in the pipeline. These legacy airlines, which have never generated huge profits, are now in some cases also in severe financial difficulty (unlike many of the so-called “no frills” airlines, with their more streamlined cost structures). Indeed, given the threat of these new business models and the high number of legacy national carriers, the economic logic for consolidation - and the benefits of reducing costs, sharing infrastructure and expanding networks - has long been compelling. So why has this not happened to date, and why is consolidation increasing now?

The national ownership problem

Airlines, which were traditionally nationally-owned, long sought to protect their position through retention of the flying rights under bilateral air services agreements (ASAs) between their home country and relevant third country destinations. These ASAs allocated a certain number of frequencies to a designated carrier (or occasionally carriers) on each side, and stipulated that the designated carrier must have an operating licence within the relevant country - qualification for which in turn required majority ownership by nationals of that state. This system prevented airlines getting flying rights under ASAs other than to or from their home country, and thus was a bar to international consolidation as acquisition by a foreign carrier risked loss of the flying rights which constituted much of an airline’s value.

Liberalisation

Within the huge US domestic market, ASAs did not apply and therefore competition thrived between the wide range of domestic carriers. However, airline ownership in the US is governed by Section 41102 of the United States Transportation Code (the USTC) which continues to make foreign ownership of an airline operating in the US impossible. As explained further below, Virgin had to make significant concessions in order to launch Virgin America, which carries the airline’s brand and connects with its international network, but remains majority-owned by US citizens with Virgin only holding a minority stake.

Within the EU, Regulation 1008/20081 (the Regulation) requires that ownership by any EU nationals be recognised for national operating licences. This has allowed carriers such as easyJet to operate hubs throughout the EU (e.g. Geneva, Milan and Madrid in addition to its UK bases). However, mergers between EU airlines still risk losing rights under ASAs with non-EU destinations to the extent that these ASAs stipulate that national (as opposed to EU) ownership is required for designated carriers.

Liberalisation has started to increase the scope for international operations under ASAs, with the landmark Open Skies agreement between the EU and the US of 30 March 2008 removing the limit on the number of designated carriers on each side and allowing US and EU airlines to fly any route between the two jurisdictions (while US carriers can also fly between points within the EU, although EU carriers cannot operate between points in the US). The EU is also currently negotiating Open Skies agreements with other jurisdictions around the world2, further increasing the recognition of EU (as opposed to national) ownership under ASAs. Australia has also successfully negotiated several such agreements, while Japan and the US entered an Open Skies agreement in December 2009.

Overcoming the ownership problem

Both the Regulation and the USTC establish conditions to be met by airlines applying for an operating licence. These include stipulations as to shareholder status, composition of the board and principal place of business. In particular, the Regulation requires that an airline is both more than 50 per cent owned and “effectively controlled” by EU nationals, while the US rules permit a maximum of 49 per cent foreign ownership and 25 per cent foreign control. On the face of it, these rules prevent airline mergers involving “foreign” owners.

While there is still considerable pressure for these ownership rules to be relaxed3, airlines are now developing more complex structural models which allow them to work around these rules and consolidate, even while the national ownership rules remain in place.

Perhaps the best way so far suggested for complying with the current ownership rules has been the “dual nationality model”. The merger of KLM and Air France demonstrated how this could be successfully implemented, and this is likely to also be the structure upon which a BA/Iberia merger is based. A stylised representation of this is set out below:

Dual Nationality Ownership Model

The model is based on each merging airline remaining sufficiently owned and controlled by nationals of the relevant country through a trust mechanism for the relevant rules to be satisfied, but allowing the joining up of group functions in a central entity owned by the shareholders of the two airlines (who are also the beneficiaries of the controlling trusts according to their nationality). The model requires careful consideration of the nationality of shareholders, and also of board members to ensure that the ownership and control rules are not breached. Rules are also required to grant veto or “golden share” type rights to the national trusts in the event of any doubt as to the ownership and control position.

In Air France/KLM, for example, a new holding company was created in which Air France initially owned an 81 per cent stake, the remainder being held by KLM. In addition, the Dutch government and two Dutch foundations held voting, non-economic shareholdings which totalled 51 per cent of the voting rights in the KLM subsidiary (i.e. replicating one side of the diagram above). Following the merger, each airline still operated as a separate entity on a day-to-day basis, and the boards of KLM and Air France, while also distinct, were composed of directors from each company (with a majority being of the relevant nationality).

As might be expected, such structures are subject to intensive review by the authorities - and the legality might also be challenged by third countries under ASAs. In the UK, particular factors to take into consideration are set out in the CAA’s guidance on ownership and control4, which state:

  • In certain circumstances the CAA may weight different classes of share according to their true economic value (as opposed to nominal value)
  • In determining control, the CAA is concerned to establish the practical reality of who is actually making a company’s decisions as well as positions which derive from legal powers and agreements. The starting point in determining control is ownership rather than management as the presumption is that the owners will have the possibility of replacing the management.
  • A single large shareholder may be considered to have a disproportionate influence in circumstances where the other shares are thinly spread and there are no mechanisms to ensure that these small shareholders exercise their votes in concert.
  • Shareholders may have certain veto rights which effectively confer negative control. However, the normal minority shareholder protection rights (e.g. veto over selling major assets; or veto over changes in capital structure) will not normally confer control.
  • Joint control between EU and non-EU persons is not permissible.
  • Special or unusual conditions in loan or lease agreements may be such as to confer a degree of control.
  • Agreements with non-EU companies to outsource key operations such as planning and pricing may confer a degree of control on the non-EU company. Similarly, control may be in the hands of a single customer or supplier if the nature of the relationship is such that the airline could not in practice continue to trade without that company’s co-operation.
  • The CAA will normally require there to be a majority of EU citizens on the board of the airline as well as taking into account quorum requirements which may restrict the extent to which decisions may be taken in the absence of an EU majority.

In terms of transatlantic merger models, the barriers remain even higher with the foreign investor strictly limited to 25 per cent control of any merger involving a US airline. In establishing Virgin America (VA), Virgin was required to make numerous concessions in order to demonstrate that it did not exceed the relevant control thresholds, for example:

  • VA was required to remove its preferred CEO - despite him being a US citizen - as it was found that his appointment by Richard Branson and long connection with Virgin meant he was “beholden” to the UK company;
  • Virgin had to relinquish all veto rights it had obtained in connection with establishing VA in order to make clear that, once operational, VA would be controlled by the US investors Virgin had brought in
  • Virgin was also required to remove a number of provisions from the loan facilities it had provided to VA, such that its consent would no longer be required before VA could undertake a number of actions such as: paying dividends; incurring senior debt; transferring certain assets; or fundamentally altering its business; and
  • Virgin was required to amend the licensing agreement under which VA used the Virgin brand in order to make clear there was no obligation to use the brand and to give VA freedom to codeshare with other carriers in the US.

Merger control

In addition to overcoming the nationality rules described above, airline mergers also need clearance from antitrust and competition authorities. In the passenger sector, this analysis is focussed on city-to-city overlaps and the standard remedy is the requirement of slot divestitures at airports to allow competitors to come in and offer a service on routes where the merging entities would otherwise dominate (e.g. Paris-Amsterdam in the case of the Air France/KLM merger).

Although such slot divestments will not typically be a deal-breaker, they can add to the regulatory price airlines face in merging. However, given the economic difficulties they currently face, many airlines are considering taking on these regulatory obstacles. Achieving the benefits of a full merger - which should lead to efficiencies including joint price setting which cannot be achieved through other cooperation models such as codeshares or alliances - may be the only way legacy carriers can compete against the models of low(er) cost carriers. But it promises to remain a bumpy ride.