In the August 2021 edition of the Vedder Price Global Transportation Finance newsletter, the article “Put Option Agreements In Aviation Financing”, accessible here, briefly summarized the origins and basic structure of the keepwell put option agreement commonly utilized by finance parties in aircraft financings involving a People’s Republic of China (the “PRC”) parent leasing company (the “PRC Parent”).
In transactions that utilize keepwell put option agreements, finance parties will typically focus on the financial and credit support undertakings provided by the PRC Parent under the keepwell put option agreement. After all, as addressed in our August 2021 article, the keepwell put option agreement is provided by the PRC Parent in lieu of a parent guarantee. In line with the focus on the PRC Parent’s role, it has become standard practice for finance parties to require sanctions and anti-money laundering undertakings from the PRC Parent in connection with such aircraft financings. However, certain risks associated with potential trade and export control restrictions and attributable to the structure of the keepwell put option arrangement can easily be overlooked by finance parties. This article highlights such risks and suggests a list of questions that the internal compliance and legal teams of finance parties may need to consider in relation to potential trade and export control restrictions when assessing the risks associated with a particular aircraft financing utilizing the keepwell put option arrangement.
In a typical aircraft financing involving a PRC Parent that utilizes a keepwell put option agreement, (i) the PRC Parent (which is considered to be “onshore” for purposes of this article) (A) forms a special purpose company (the “SPC”) outside of the PRC (which is considered to be “offshore” for purposes of this article) and (B) owns, directly or indirectly, the shares in the SPC; (ii) the finance parties (which are considered to be “offshore” for purposes of this article) make a loan to the SPC; (iii) the SPC leases the aircraft to an airline (the “Leasing Arrangement”); (iv) the SPC grants security over the aircraft and the lease agreement relating to the Leasing Arrangement in favor of the finance parties; and (v) the PRC Parent provides a keepwell put option agreement in favor of the finance parties to support the obligations of the SPC under the aircraft financing.
In the context of aircraft financing, the put option agreement is a keepwell arrangement which allows the security trustee on behalf of the finance parties to require the SPC, as borrower (the “Borrower”), to sell, and the onshore PRC Parent to purchase, the financed aircraft following a loan event of default (the “Purchase Arrangement”). Using the put option structure with the pretext of purchasing the aircraft, the PRC Parent has an ostensibly legitimate reason to transfer funds to the offshore Borrower, and such funds can in turn be used to satisfy outstanding loans owed under the aircraft financing. Under a purchase option structure, the PRC Parent provides the liquidity support and undertakings to support the offshore aircraft financing by entering into the put option agreement.
Finance parties consider many different aspects when assessing the risks associated with a particular aircraft financing, including, among other things, financial, credit and asset risks. In a particular aircraft financing utilizing the keepwell put option arrangement described above, an often overlooked structural risk exists due to the Leasing Arrangement and the Purchase Arrangement, as both instances may entail a transfer of the aircraft from one jurisdiction to another. Internal compliance and legal teams of finance parties would be prudent to consider trade regulations of the United States and other relevant jurisdictions designed to control the export of certain aircraft products and technologies to certain end users. There are potentially two tiers of transactions that could trigger export restrictions that merit consideration by internal compliance and legal teams: (i) the Leasing Arrangement (i.e., the leasing of the aircraft by the Borrower to the airline) and (ii) the Purchase Arrangement (i.e., the transfer of the aircraft from the SPC to the PRC Parent in the event the put option under the keepwell put option agreement is exercised).
The United States trade regulations, for example, are designed to control the export of certain U.S. products and technologies to certain countries and end users, and also to block U.S. parties from engaging in transactions with sanctioned parties. Through export controls, the United States monitors the export of controlled items — components, technology and technical data — and restricts such export through licensing, where necessary. Sanctions can be used to block certain categories of transactions with certain entities. Further, the U.S. government has designated a list of entities as “military end users” that are subject to enhanced export controls. The United States has a policy of denying applications for licenses to export certain controlled products to military end users, including end users in the PRC.
The export of non-military aircraft is regulated by the Export Administration Regulations (“EAR”), 15 C.F.R. §§ 730 et seq. Aircraft are controlled items, which means the U.S. Commerce Department’s Bureau of Industry and Security (“BIS”) has enumerated restrictions on their export, including, in some instances, licensing requirements. Controlled products are categorized with an Export Control Classification Number (“ECCN”) classification on the Commerce Control List, where the specific licensing requirements and restrictions are listed by ECCN number. If an export license is required, then an application to BIS identifying the parties to the transaction, including the end user and end use, will need to be submitted.
In a typical aircraft financing utilizing the keepwell put option arrangement, it is not unusual (i) for the Borrower to lease a Boeing or Airbus model commercial passenger aircraft to an airline located or habitually based outside of the PRC (the “Foreign Airline Jurisdiction”) pursuant to a lease agreement and (ii) for the airline to use and operate the aircraft in the Foreign Airline Jurisdiction and/or internationally. While the facts and circumstances particular to each aircraft financing (e.g., the location of the Foreign Airline Jurisdiction, the identity of the airline, the Borrower’s jurisdiction of incorporation, the proper ECCN classification for the aircraft and leasing of new or used aircraft, among other things) would need to be considered, the SPC is unlikely to be considered the end user of the aircraft in this context initially (after all, it is the airline that uses and operates the aircraft). However, it may be important for internal compliance and legal teams to further consider whether or not the transaction would be permissible if the SPC were the end user. This is because the SPC could terminate the lease with the airline and take possession of the aircraft, thereby possibly becoming an end user itself. Put differently, even if the airline was a low-risk end user under initial assessment of the trade and export control regulations, there is a risk that the parties to this transaction could make a decision that would replace a lower-risk end user with a higher risk end user, in the case where the SPC is an entity subject to trade and export control regulations. Therefore, from a risk standpoint, finance parties should consider whether the SPC could be an end user or a military end user and whether or not trade and export control regulations would apply in this circumstance. As an end user or a military end user, export licenses may be required upon assessment of the relevant trade and export control regulations.
Although the aircraft financing is structured so that the airline will use and operate the aircraft under the Leasing Arrangement, the SPC itself owns and holds title to the aircraft. In the event the Purchase Arrangement occurs (i.e., the finance parties have exercised their put option under the keepwell put option agreement, thereby requiring the PRC Parent to purchase the aircraft from the SPC), the PRC Parent takes title to the aircraft and becomes its owner. From a risk standpoint, the finance parties should consider whether the PRC Parent could be deemed to be an end user or a military end user and, if so, whether trade and export control regulations would apply to the Purchase Arrangement and if export licenses may be required. For example, if trade and export control regulations do apply to the Purchase Arrangement and required licenses are not (or cannot be) procured by the PRC Parent, this raises the query whether the PRC Parent could or would be permitted to pay the purchase price under the keepwell put option agreement. This may materially impact the finance parties’ ability to fully utilize the liquidity and structural support offered by the keepwell put option arrangement.
Likewise, the finance parties would need to consider whether the Purchase Arrangement would trigger a transfer of the aircraft from one jurisdiction (e.g., the Foreign Airline Jurisdiction) to the PRC because that transfer may constitute a re-export subject to the EAR or other similar export control regulations. The potential export of the aircraft from one jurisdiction to the PRC in the event the put option under the keepwell put option arrangement is exercised may constitute a re-export to the PRC that could require an export license under relevant trade and export control regulations. Similar to the above, whether or not licenses are required and whether such licenses may not (or cannot) be procured by the PRC Parent, may have a material impact on the finance parties’ risk and credit assessment of the aircraft financing.
Therefore, to more fully assess the risks associated with an aircraft financing utilizing a keepwell put option structure, it may be useful for the internal compliance and legal teams of the finance parties to ask the following questions:
- Question #1: Do the finance parties have any reason to believe that the ultimate end user of the aircraft will be the SPC or the PRC Parent?
- Question #2: Do the finance parties have any reason to believe that the SPC or the PRC Parent could be considered a military end user?
- Question #3: Do the finance parties have any reason to believe that an export license will be required?
- Question #4: Do the finance parties have any reason to believe that the Purchase Arrangement would be considered an export thereby requiring enhanced trade and export control analysis?
While the list of questions above is by no means comprehensive, the internal compliance and legal teams of finance parties are encouraged to at least initially consider these questions in relation to potential trade and export control restrictions that may apply to their aircraft financings utilizing a keepwell put option arrangement. Whether a transaction would be subject to trade and export control regulations tends to be specific to the relevant facts and circumstances particular to that transaction. Therefore, this article is not intended as an in-depth analysis or assessment of trade and export control regulations that may be relevant to a particular aircraft financing keepwell put option arrangement, the SPC or the PRC Parent. However, this article highlights a structural risk often overlooked by finance parties that merit further consideration while assessing the overall risks associated with such aircraft financings.
Internal compliance and legal teams of finance parties are encouraged to consult a member of the Vedder Price Global Transportation Finance and International Trade & Compliance teams for advice regarding trade and export control regulations that may be particular to the facts and circumstances of their transactions.