Indentures and other agreements governing complex, multitiered structured debt products will typically contain a series of reserves, the adequacy of whose funding will take precedence over payments to noteholders. While the funding requirements of the reserve accounts will be set forth in the agreement, the formulation of these provisions will leave administrators considerable leeway in determining the cash maintenance levels appropriate for the various accounts. In a recent case, UMB National Association v. Airplanes Limited (S.D.N.Y. May 26, 2017), a court sided with a trustee who maintained that reserves were mischaracterized and inflated by the issuer. While involving the particular scenario of an insolvent and nonoperational entity, the case nonetheless is instructive for noteholders seeking to challenge what they regard as abuses of discretion relating to the maintenance of reserves.

Facts

Defendants Airplanes Limited and Airplanes U.S. Trust, often referred to individually and collectively in the decision as “Airplanes,” were formed to acquire, lease and sell aircraft. In 1996, Airplanes Limited acquired a fleet of aircraft financed with the issuance of $3.68 billion worth of notes — apportioned among subclasses A-1 through A-9, class B, class C and class D — to a series of pass-through trusts. The trusts in turn issued mirror certificates to investors. The notes were guaranteed by Airplanes U.S. Trust.

By the time of the decision, Airplanes was insolvent and no longer operational, having disposed of all of its aircraft. It had paid or refinanced the notes in subclasses A-1 through A-8, but the remainder of the notes were outstanding and unpaid.

In the 1990s, Airplanes leased two aircraft to a now-defunct Brazilian carrier by the name of Transbrasil. The carrier ultimately defaulted under the leases, and GE Capital Aviation Services, which had been retained to negotiate and service the leases, undertook a collection action in Brazil. In 2007, a Brazilian court entered a judgment requiring Airplanes to pay Transbrasil twice the amount of the promissory notes on the leases, plus interest and damages. The Brazilian court found that the debt had already been paid and that the collection action was malicious and litigated in bad faith. In October 2013, however, the federal court of appeals in Brazil overturned key portions of the lower court judgment.

The Reserves

The indenture governing the notes contained a maintenance reserve account and a required expense amount. The maintenance reserve account was, as its name implies, intended to cover certain expenses associated with aircraft maintenance. Once Airplanes sold its final aircraft, the indenture required that this account be reduced to zero. As a result, in 2016, Airplanes reclassified the funds in the maintenance reserve account to the required expense amount. The required expense amount was defined to include, among other things, expenses due and payable on the calculation date related to the respective payment date, or “reasonably anticipated to become due and payable before the end of the Interest Accrual Period beginning on such date” (emphasis supplied; see below).

Beginning in July 2012, Airplanes suspended all required payments on the subclass A-9 notes, which had a balance of $627 million, in order to direct available funds into the maintenance reserve to cover the liability against Transbrasil. The reserve for this liability was periodically increased until it grew to $190 million in November 2015. Finally, in April 2017, Airplanes filed a letter with the court stating that after its review of the Brazilian court decisions, it was proposing to reduce the reserve from $190 million to $46 million. 

Plaintiff UMB served as senior trustee and security trustee under the indenture governing the notes. It argued that Airplanes had wrongly classified the reserve because the Transbrasil judgment was not “anticipated to become due and payable,” as required for the expense reserve amount.1

The Court’s Decision

The court first recited the customary legal principles under New York law: how an indenture is to be interpreted using basic contract law; how interpretation of unambiguous provisions are to be addressed by the court; how the court must look to the document in its entirety and not clauses in isolation; and how a court must reject interpretations that are commercially unreasonable or illogical. It then proceeded to interpret the word “anticipated.”

The parties cited to dictionary definitions of the word “anticipate,” with the plaintiff relying on the definition “to look forward to as certain,” while the defendants pointed to the definitions  “to give advance thought, discussion, or treatment to” and “to foresee and deal with in advance.” The court, basing itself on cases in other contexts and in other jurisdictions, chose a middle ground. In its view, an anticipated liability “need not be certain, but it must be more than speculative, conjectural or hypothetical.” 

Employing its middle-of-the-road definition, the court found that the Transbrasil liability could not be regarded as being “anticipated.” While Transbrasil had filed a motion with the Brazilian court of appeals for reconsideration, there was no well-founded basis that the court would reverse itself or that Brazil’s Supreme Court would overturn the ruling of the lower appellate court.

The court next turned to the question of whether the $46 million reserve that Airplanes now proposed to maintain was reasonable, but declared that this “fact intensive issue” had been inadequately briefed. The court therefore directed counsel for Airplanes to file a sworn declaration setting forth in detail the quantitative basis for the reserve amount that Airplanes proposed to maintain and that was unrelated to the Transbrasil liability. Airplanes was directed to attach supporting documentation, and was also required to state when it first determined that each component of the reserve, and its amount, was justified.2

Observations

It is not often that judicial decisions come along in which the adequacy of indenture reserves are challenged. Indeed, the Airplanes decision cites no precedent for such a challenge. The case is a useful reminder, however, that, at least in some instances, the amount of an indenture reserve is fair game for judicial review, and that a court will not blindly accept an issuer’s conclusions that reserves are necessary or justified.

The case also serves as a data point for interpretation of the concept of “anticipation,” which is often used to qualify liabilities for which indenture reserves may be taken. To be filed away for future reference!