Financiers will be reassessing the credit analysis for their aircraft financing transactions involving onshore PRC lessors who have leased aircraft to PRC airlines following the recent practice in relation to “internal transactions” under the Cape Town Convention and the Aircraft Protocol (the “Convention”).In this article, we analyse the impact of a transaction being viewed as an internal transaction. Financiers should seek legal advice on how to best protect their interests where a financing and leasing transaction may constitute an internal transaction in the PRC.
King & Wood Mallesons is able to help you navigate the local legal landscape whether from the English law or other international law documentation perspective, the protections that may be available under the Convention and the analysis under PRC law and practice.
The Convention offers protections to financiers of aircraft objects through a streamlined regime intended to provide financiers with greater predictability.
This is balanced with flexibility for ratifying countries to apply or disapply certain provisions of the Convention in particular circumstances. This optionality caters for differing levels of “creditor-friendliness” countries wish to provide for parties transacting in their jurisdiction, and to better adapt the Convention to its domestic laws.
Representing an asset class that remains unique and challenging for most financiers, the level of liquidity in the aviation asset class is relatively buoyant and increasingly attractive both to international financiers specialising in asset finance as well as local relationship based financiers. With over 65 countries having ratified or in the process of ratifying the Convention, through the reliance on the security and enforcement protections afforded under the Convention, financiers are better able to make a positive credit decision in respect of funding against the asset class.
A significant tangible benefit of the Convention is the ability to exercise certain interim remedies, including a documentary remedy (known as an Irrevocable De-registration and Export Request Authorisation (IDERA)) which can be exercised with the assistance of the aviation registry at which aircraft is registered (in some cases, even without the benefit of a court order). The process involves the party in whose name the aircraft is registered granting the IDERA and the IDERA being recorded with the aviation authority.
Aviation authorities (including the CAAC in the PRC) will only record an IDERA if the Convention applies to the transaction. Since aircraft are registered and operated in the name of airlines in the PRC, the IDERA would need to be granted by the PRC airline.
From a financier perspective, the availability of an IDERA is important as it provides financiers (either in their own name, or if granted to the lessors that the financiers are financing, acting through the remedies available against the lessors) the ability to de-register the aircraft in an airline default situation. This would have the effect of immobilising the aircraft, thereby preventing use of the aircraft while final remedies are being sought against the airline and making it easier to locate the aircraft and manage “flight risk” from a repossession perspective.
Financier will also understand that certain interim remedies although available in theory are practically unavailable in an enforcement scenario or while available cannot necessarily be exercised in the short timeframes contemplated under the Convention. This is not unique to a PRC based transaction.
Leases between a Chinese lessor and a Chinese lessee is viewed in practice as an internal transaction notwithstanding the offshore financing elements
Under Article 50(1) of Convention, a ratifying country may declare that the Convention does not apply to an internal transaction (the Internal Transaction Declaration). China is one of the ratifying countries that has made such a declaration.
The significance of the Internal Transaction Declaration has been magnified by the view in relation to transactions where PRC lessors have funded themselves through offshore financiers in respect of aircraft which are then leased to PRC airlines.
It is not clear whether the Convention is intended to “spring into effect” and requires treatment of the whole transaction as an international transaction at the time the offshore elements come into effect. It is less clear however where the offshore financing elements are a fundamental part of the wider transaction at the time the leasing transaction is concluded. For example, the lessor entity may be a PRC special purpose vehicle which can only acquire the aircraft for the purposes of leasing it to the PRC airline with the benefit of the offshore financing.
What is clear is that under current practice, the leasing leg of a transaction will be viewed as being independent from the financing leg. Despite of the involvement of foreign financiers, given that each of the lessor and the lessee of the aircraft in these transactions are Chinese entities, the leasing leg of a transaction, under current practice, will be viewed as an internal transaction and subject to the Internal Transaction Declaration.
One consequence of taking the view that the lease transaction is an internal transaction is that the CAAC will not accept requests for the recordation of an IDERA on such transactions.
A wider impact is that the broader protections available under the Convention, including interim remedies such as the comfort that financiers have of being able to immobilise an aircraft through the exercise of a recorded IDERA, are not available on the leasing leg of such transactions.
As it may be fundamental to any credit decision to analyse the repossession risk associated with a transaction, this current state of affairs would force most financiers to reassess their credit analysis of a transaction.
Given the various advantages for aircraft lessors and airlines in using a Chinese lessor entity in Chinese aircraft financing and leasing transactions, whether from a tax optimisation standpoint or to better enable aircraft lessors to position themselves to tap into the China growth story, and the importance to financiers of reliance on protections afforded under the Convention in order to get comfortable with the jurisdiction from a security perspective, it is imperative that financiers understand the consequences of, and mitigants to, the current practice with respect of internal transactions and the unavailability of the benefit of an IDERA on those structures.
King & Wood Mallesons, through its appointment on the Aviation Working Group for China, has developed analysis from a contractual, Convention and local law perspective to give comfort to its clients as well as the aviation industry in respect of this view. KWM has also been involved in the only publicly known instance where repossession action has been successfully taken against a PRC aircraft operator with the benefit of local law protections for creditors.
When is a transaction an internal transaction under the Convention?
For a transaction to be an internal transaction it must meet three criteria:
- the interest in question must meet the requirements of what would otherwise engage the application of the Convention. The Convention protects interests of “creditors” under certain types of agreements, being a chargee under a security agreement, the conditional seller under a title reservation agreement, the lessor under a leasing agreement and a buyer under a contract of sale between the date of the contract of sale and closing;
- the centre of the main interests of all parties to the transaction must be situated, and the relevant object located, in the same ratifying country at the time of the conclusion of the contract; and
- the interests created by the transaction must have been registered in a national registry in the ratifying country which has made the Internal Transaction Declaration.
If a transaction is an internal transaction, financiers have the benefit of some protections under the Convention that are deemed to apply
Notwithstanding the expression used in the Convention in respect of the Internal Transaction Declaration that countries can choose “not to apply” the Convention for internal transactions, one should note that certain substantive protections afforded by the Convention are deemed to apply to internal transactions.
In particular, the Convention provides that two important remedies are deemed to apply to an internal transaction:
- the priority regime applicable to registered and unregistered interests remains applicable. This is particularly important given that the “national interest” that exists under an internal transaction can be registered on the International Registry (as set out below); and
- Article 30 of the Convention (which deals with the effects of insolvency) remains applicable to the national interest, and China has adopted Alternative A (China’s declarations under the base Convention can be found here, and China’s declarations under the Aircraft Protocol can be found here.
This addresses two key baseline protections for secured financiers, namely, the ability to assert priority of one’s security interest against third parties, and secondly, the ability to assert that security interest against the insolvency practitioner in the event the security provider is insolvent. Alternative A goes one step further and requires the insolvency practitioner, in this case, the PRC airline, either, to cure all defaults (other than any insolvency related default) and agree to perform all future obligations under the lease, or, become disentitled to retain possession of the aircraft at the end of 60 calendar days. During those 60 calendar days, the insolvency practitioner must preserve the aircraft and maintain it and its value in accordance with the lease.
If financiers (acting through the lessor) are able to assert priority over subsequently registered and unregistered interests in the lease or directly through a security assignment of the lease granted by the lessor to the financiers, and have the benefit of the insolvency protection, then, in the authors’ view, this gives financiers some comfort relying on the Convention from a credit decision standpoint.
In theory, these protections should also be available for PRC based internal transactions. Whether these protections are available in practice must be considered when structuring transactions, and to the extent unavailable, financiers will need to rely on the local law analysis.