New legislation released at the end of March 2009, has introduced the Aircraft Pfandbrief to the covered bond market. This Pfandbrief can be used by financial institutions in the German KG market to refinance aircraft loans. A new chapter has been opened in the German Pfandbriefe story, i.e. mortgage covered bonds which were introduced in Prussia in 1769.

The Pfandbrief under German law is an internationally recognised type of covered bond. It enjoys great popularity among investors due to its favourable refinancing possibilities, and is thus more interesting than, for example, covered bonds offered in other countries. The Pfandbrief’s high level of security results from a combination of safety mechanisms. Particularly in the current market, there is high demand for refinancing instruments with low default probabilities.

The introduction of the Aircraft Pfandbrief is intended to support the leading position of German financial institutions in the aircraft financing market; it potentially offers a reliable hedging tool for the growing aviation market and facilitates the refinancing of credit institutions by means of the German Pfandbrief mechanism.

Pfandbriefe can be issued in four different classes depending on the type of security. They can be secured by loans to public authorities (Public Pfandbriefe), mortgage backed loans (Mortgage Pfandbriefe), ship loans (Ship Pfandbriefe) and aircraft loans (Aircraft Pfandbriefe).

The first part of this article deals with the general requirements for issuing a Pfandbrief in Germany and the second part introduces the Aircraft Pfandbrief.

General Conditions for Pfandbriefe covered bond issues

In order to engage in the Pfandbrief business in Germany, a specific licence is required from the Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht; the BaFin). It can be restricted to certain Pfandbrief classes (Aircraft, Mortgage, Public or Ship Pfandbrief). The Pfandbrief Act distinguishes between German banks and foreign credit institutions domiciled in the European Union (EU).  

Credit institutions domiciled in Germany

In order to obtain a Pfandbrief licence in Germany, the following conditions have to be met:

  • minimum core capital of € 25m;
  • a bank licence;
  • a business plan demonstrating that the credit institution will engage in the Pfandbrief business on a regular and sustained basis;
  • creation of a risk management structure for the cover assets; and
  • an appropriate organisational structure.

The Pfandbrief licence is issued separately for each Pfandbrief class. In certain circumstances, the BaFin may subsequently revoke a licence, such as, in particular, if the Pfandbrief bank has not issued any Pfandbriefe in the previous two years and is not expected to resume Pfandbrief business within the next six months as a regular and sustained banking business.

Credit institutions domiciled in the EU

Foreign credit institutions domiciled in the EU may only put bonds into circulation using the designation “Pfandbrief” (or “Aircraft Pfandbrief”, “Mortgage Pfandbrief”, “Public Pfandbrief” or “Ship Pfandbrief”) if the following conditions set out in the Pfandbrief Act are met. A separate Pfandbrief licence from the BaFin is not required, if:

  • the credit institution is a deposit-taking credit institution (Einlagen-Kreditinstitut) having its seat in another member state or another EEA contracting state;
  • the issue of bonds under any one of the designations specified above is also licensed in the home country of the institution;
  • the bonds qualify as bonds for the purposes of the UCITS directive (Directive 85/611/EC), and if the bonds are included in a list sent to the Commission by the home country of the credit institution;
  • the mortgages, ship mortgages and aircraft registered lien or the foreign registered lien used as cover do not exceed a limit of 50 per cent of the market value or 60 per cent of the amount of the mortgage; and
  • when designating the bond in all prospectuses, reports and advertising material, any foreign-language original designation of the Pfandbrief is indicated and it is pointed out that the bond is issued under the relevant foreign law.

The details have been set out by the BaFin in its guidance notices dated 2 April 2005 and 6 January 2009.  

Further requirements of the German Pfandbrief Act

The assets used to cover the Pfandbriefe, e.g. an aircraft registered lien securing the aircraft loan, must be recorded by the Pfandbrief bank in a cover register (Deckungsregister). A separate cover register therefore must be kept for each Pfandbrief class.

The Pfandbrief bank has to establish an asset-liability management system ensuring that the cover of the total amount of Pfandbriefe outstanding in any one class must at all times equal or exceed their net present value (cover at net present value). The net present value of registered cover assets must exceed the total amount of liabilities to be covered by 2 per cent (excess cover).

A fiduciary agent (Treuhänder) and at least one deputy is appointed by the BaFin after consultations with the Pfandbrief bank. The fiduciary agent must possess the knowledge and experience necessary to fulfil his duties; he must be independent from instructions given by the BaFin or the Pfandbrief bank. For instance, there cannot have been an employment or client relationship with the Pfandbrief bank in the current or three preceding years. The most important duty of the fiduciary agent is to monitor the prescribed cover of the Pfandbriefe. The assets recorded in the cover register may not be cancelled in the register without the fiduciary agent’s consent.

The Pfandbrief Act contains detailed provisions on the risk management system in order to further improve protection for Pfandbrief creditors. In particular, the risk management system must ensure that the concentration of risks is limited by means of a limitation system and that a procedure is in place which ensures risk reduction in case of a material increase in risk, and that a warning procedure is in place to forward information immediately to decision-makers.

Furthermore, the transparency provisions of the Pfandbrief Act are intended to permit investors to assess the relevant risks in the best possible manner. Relevant information must be disclosed on a quarterly basis in a publicly accessible form as well as in the notes to the annual financial statements.  

Finally, the issuance and the ongoing business is supervised and monitored by the BaFin which makes random checks on the cover of the Pfandbriefe.

The Pfandbrief bank has to publish a prospectus at the time of issuing a Pfandbrief.

Insolvency of the Pfandbrief bank

The advantage of Pfandbriefe which makes them a very crisis resistant refinancing instrument is the separation of assets on a Pfandbrief bank’s insolvency. The Pfandbrief bank is exclusively liable to the Pfandbrief creditors in respect of the security recorded in the cover register. It constitutes separate assets for preferential satisfaction of the Pfandbrief creditors’ claims and is not part of the bank’s general insolvency estate. The claims of the Pfandbrief creditors are not affected by the commencement of insolvency proceedings against the assets of the Pfandbrief bank. Pfandbrief creditors participate in the bank’s insolvency proceedings only to a limited extent. They may assert their claims only in the amount of the shortfall, if there is any in respect of the cover assets.

In order to ensure this, the German Pfandbrief Act requires the local court to appoint a cover pool administrator, at the latest upon the opening of insolvency proceedings, who supervises the due distribution of the cover assets to the Pfandbrief creditors. If, in case of insolvent cover assets, not all the Pfandbrief creditor claims can be satisfied in a timely manner, separate insolvency proceedings are opened in respect of the affected cover assets. This results from the requirement that a separate cover fund is created for each Pfandbrief class (aircraft, mortgage, public, ship Pfandbrief).

The strict requirements in the Pfandbrief Act (and its predecessor, the Mortgage Banks Act (1900-2005)) regarding transparency as well as the quality of cover assets and risk management have ensured that no Pfandbrief or Pfandbrief bank has become insolvent in the last 100 years.

Conditions for an Aircraft Pfandbrief to be issued

The provisions concerning the Aircraft Pfandbrief (sections 26a-26f) in the amendment to the Pfandbrief Act in force since 26 March 2009 substantially follow the provisions concerning Ship Pfandbriefe, enacted in 1933. An aircraft registered lien can now be used as cover for the Pfandbriefe and registered in a cover register. In addition to the standard requirements, such as the BaFin’s licence (see above), the issuance of an Aircraft Pfandbrief is subject to the following conditions:  

Conditions for German aircraft

The aircraft has to be registered in the register of the German Federal Office of Civil Aviation (Luftfahrtbundesamt); The loan, including future loans, which is/are to be secured by an aircraft registered lien (Registerpfandrecht), is/are subject to the following conditions:

  • the first drawdown must be within two years, in exceptional cases five years, after issuance of the lien,
  • the maximum term of the aircraft mortgage as security is 20 years, and
  • the credit agreement type of the loan must be classified as a loan payable by instalments (Abzahlungsdarlehen);

The entry of a registered lien has to be filed with the local court (Amtsgericht) of Braunschweig which is the central registration court. Appropriate measures shall ensure that the registered lien will also include the engines. The engines are, according to German property law, accessories and are on principle included in the aircraft registered lien. In practice, a corresponding declaration upon creation of the lien suffices. The deed regarding the creation usually states that the lien also covers the engines and any replacement engines, as far as these are the property of the mortgagor. The registered cover assets also comprise all claims which would be included in the registered lien, as well as rent and lease claims, claims regarding the transfer of the aircraft and claims regarding the distribution of the sale proceeds;

The mortgage lending limit will be 60 per cent of the aircraft’s lending value. This means that the security may be included in the cover register up to this amount;

There is an obligation to insure the aircraft for the entire duration of the loan for an amount equal to 110 per cent of the respective outstanding loan claims; and

If only a partial claim is used for coverage, the bank must present a traceable documentation of the process.  

Conditions for aircraft registered abroad

Foreign registered liens regarding aircraft registered abroad can also be included in the bank’s cover fund, if they meet the following conditions:

  • The first-ranking security over the aircraft shall be recorded in a public register in accordance with the laws of the country in which the aircraft is registered. If entry in a public register is not necessary, but possible for a valid creation of an Aircraft Pfandbrief abroad, the Pfandbrief bank shall make the entry in the public register;
  • The secured loan must be an instalment loan (Abzahlungsdarlehen);
  • The foreign registered lien must provide the creditor with a security comparable to the German registered lien and with the possibility of foreclosure;
  • Any legal action must not be more difficult for foreign creditors than it is for domestic creditors; and
  • In countries outside the EU in which there is no preferential satisfaction of registered lien creditors to the general insolvency creditors in case of the Pfandbrief bank’s insolvency, only 20 per cent of the total amount of claims can be included in the bank’s cover fund.

Enforcement of the registered lien and total loss of the aircraft

Enforcement of German registered liens  

Aircraft registered liens recorded in a cover register shall only be attached or foreclosed in respect of the claims under the respective Pfandbriefe, including the claims under the derivatives recorded in the respective cover register. Foreclosure with regard to the aircraft is possible for the Pfandbrief creditor, subject to the provisions of the German Act on Forced Sale and Mandatory Administration (Gesetz über die Zwangsversteigerung und Zwangsverwaltung - ZVG). German registered liens are realised by way of foreclosure sale. A fiduciary agent may use the aircraft until the sale takes place in order to generate revenues. The registered lien also covers interest rate claims, the costs of terminating the lien and the costs of legal action.  

Enforcement of foreign registered liens

In case of foreign registered liens, the applicable law is that of the country in which the aircraft is registered.  

In the Geneva Convention on the International Recognition of Rights in Aircraft (the Geneva Convention), the contracting states undertake to recognise mortgages, hypotheques and similar rights in aircraft if:

  • the aircraft was regularly registered;
  • such rights were validly created; and
  • such rights have been regularly recorded in a public record.

No rights other than compensation due for salvage and preservation of the aircraft, customs and fees may take priority over the registered liens.

The proceedings of the sale of an aircraft in enforcement proceedings shall be determined by the law of the state where the sale takes place. Although the Geneva Convention has been ratified by 89 countries and is thus widely used, countries such as Great Britain, Canada and Australia have not signed it.

According to the Cape Town Convention, creditors can have interests in aircraft and engines recorded in an international register and can thus assert preferential rights in rem. The Convention applies when a debtor was situated in a contracting state at the time of the conclusion of the agreement creating or providing for the interest.

Change of jurisdiction

As the Cape Town Convention has not yet been ratified by Germany, the Pfandbrief Act imposes a legal duty on changing the place of registration of aircraft. If there is a transfer of an aircraft between registers, the issuing credit institution must consider its effect on registered liens. If a new foreign lien is created, there must be no impairment of security.  

Total loss of the aircraft

In case of a total loss of the aircraft, e.g. due to a crash, the registered lien extends to a claim against the insurer.

Cover assets and reporting obligations

Up to 60 per cent of an aircraft’s mortgage lending value can be included in the bank’s cover fund. Furthermore, additional cover assets, such as certain bonds and derivatives, may be recorded in the cover register. So, for example, by allocating such derivatives to the cover fund, Pfandbrief banks can prevent general insolvency creditors from accessing them.

The aircraft’s mortgage lending value is assessed by an independent expert. In practice, the value of the aircraft will be determined on the basis of the market standard of the International Society of Transport Aircraft Trading (ISTAT).

The outstanding respective total amount and term structure of the Aircraft Pfandbriefe shall be published on a quarterly basis, as for other Pfandbriefe (see above regarding transparency).

Transfer of interest and fiduciary security

The registered lien is intrinsically linked to the underlying loan claim. The registered lien and the secured claim may only be transferred together.

A Pfandbrief bank may also include security with the cover assets held by another credit institution acting as its fiduciary agent. However, such security must be recorded in a separate refinancing register. The refinancing register ensures that charges over real property held in a fiduciary capacity are insolvency-remote. In the case of the credit institution’s insolvency, the Pfandbrief bank may request the separation of the security held by the credit institution which is acting as fiduciary agent (registered liens regarding the aircraft, mortgage, etc.).

The future for the AircraftPfandbrief

The German Pfandbrief Act provides a clear regulatory basis for supervision, insolvency of the issuer, transparency and monitoring of the cover assets.

The Pfandbrief covers over 20 per cent of the German bond market and is now amended by the Aircraft Pfandbrief as a new asset class.

The Pfandbrief provides access to liquidity at any time and no Pfandbrief has turned out to be non-performing in the last 100 years.

Despite the current liquidity crisis in the financial markets, some participants estimate that the market for aircraft financings will reach an annual new business volume of € 44bn in the next five years. The Aircraft Pfandbrief will help meet the current demand: “Safe investments such as Pfandbriefe and government bonds are the only things investors are currently looking for.” (Frankfurter Allgemeine Zeitung 4 January 2009.)