Recent developments in economic sanctions and export controls, including those related to Russia and Iran, have impacted aviation finance and leasing. It is important to take into account the possible effects of sanctions, present and future, when negotiating and entering into an aircraft lease.

Russia: Dobrolet sanctioned by the EU

On July 30, 2014, the EU ordered the freezing of the funds of Dobrolet, a subsidiary of Aeroflot that operated flights between Moscow and Simferopol, Crimea. As a result of the asset freeze, it is prohibited for EU persons to provide any funds or economic resources to Dobrolet. The EU explained its designation by noting that Dobrolet “facilitates the integration of the illegally annexed Autonomous Republic of Crimea into the Russian Federation and undermines Ukrainian sovereignty and territorial integrity.”

As a consequence of the sanctions, Dobrolet reported that its lessors cancelled its leasing agreements, and that it had suspended its operations as of August 4, 2014. The lessors were presumably impacted by the freezing of Dobrolet’s funds and the negative impacts on Dobrolet’s ability to effect its payment obligations under the lease agreements. 

The EU sanctions against Dobrolet raise the question whether other Russian air carriers or at least other subsidiaries of Aeroflot that operate flights to the Crimea region could be sanctioned similarly going forward. So far this has not occurred, and the United States has not followed the EU in imposing sanctions on Dobrolet. The reason may be that these other Russian air carriers have broader operations to other destinations within and outside Russia. 

Whether the crisis in and around Ukraine will give rise to further sanctions – either additional designated persons or an expansion of the sector-specific sanctions to additional industries such as the aviation industry – will depend on the further development of the political situation and is difficult to predict.

Iran: authorized US exports for flight safety

While most US sanctions targeting Iran remain in place, the US government has authorized certain specific exports of goods and services to the Iranian aviation sector. These exports were authorized pursuant to the Joint Plan of Action agreed between Iran and six other countries, which has been in effect from January 20, 2014, and as extended will continue through November 24, 2014. 

The US government has implemented a permissive licensing regime, under which it will generally issue specific licenses, upon application, authorizing the provision of spare parts, other equipment, and services necessary for civil aviation flight safety to Iran Air or to other airlines in Iran (other than Mahan Air or other airlines on the US list of Specially Designated Nationals (SDN list)).

These specific licenses are issued on a case-by-case basis, and licenses issued pursuant to this policy are given an expiration date of November 24, 2014. All activities pursuant to the licenses, including payments, must be completed by that date.

US export control reform has created greater complexity for the aviation sector

In 2009, the Obama Administration launched a broad-based reform effort aimed at the US export controls administered by the Bureau of Industry and Security (BIS) and several other US government agencies. The reforms sought to strike a balance between reducing controls on less sensitive items and maintaining more precise control over sensitive items with military capabilities. The reforms that have come into effect create new challenges for companies trying to implement them.

Changes in the export control rules will likely significantly impact companies in the aerospace sector. These rule changes will result in modifications to existing licensing processes and other compliance challenges for exporters and manufacturers. This includes a more complex set of steps to determine whether US government approval is required to export controlled products or transfer controlled software or technology to non-US citizens. The first set of reforms, which took effect in October 2013, included reclassification of many aircraft and aircraft parts. Many parts and components specially designed for military aircraft are now controlled by the BIS under the Export Administration Regulations (EAR), rather than by the US State Department under the International Traffic in Arms Regulations (ITAR).

A license exception in the EAR titled Strategic Trade Authorization (STA) was unveiled in 2011 and recently revised. STA authorizes the export of a number of items, including most 600-series items, to 36 “low risk” countries without a license, if the items are to be used by the governments of these countries or will be returned to the United States or exported in connection with an existing authorization. The covered countries include Canada, Japan, the UK, Germany, South Korea, and the Netherlands. 

License exception STA has the potential to make certain exports more straightforward. Relatively few companies have been using STA, however, for a number of reasons. For example, exporters must maintain certain records and provide certain information to the recipient, and must obtain a consignee statement that the consignee is aware of the item’s classification and restriction on its reexport or transfer.

Sanctions and export control provisions in aircraft leases

Carefully drafted sanctions and export controls language in lease agreements can provide protection to aviation lessors if sanctions are imposed on a lessee. Aircraft operating leases customarily address two different sanctions compliance risks: (a) sanctions may adversely affect the leasing of the aircraft from the lessor to the lessee, and (b) the operation of the aircraft by the lessee may trigger a sanctions violation.

  1. Sanctions impacting the continuation of the lease: regarding the risk that new economic sanctions prohibit the continued lease of the aircraft, as between the lessor and the lessee this risk is usually addressed by an illegality clause in the lease agreement. This clause leads either directly to a termination right or to a mitigation process followed by a termination right upon failure of the mitigation. The allocation of the economic burden of such termination varies depending on the parties’ economic interests and the relative bargaining power of the lessor and lessee.

Existing lease arrangements where the delivery of the aircraft has already occurred may be affected if sanctions hinder the ability of the lessee to make its required payments under the lease. If payments are prohibited or the lessee’s funds are frozen and the lessee breaches its payment obligations, an immediate termination right is customarily available to the lessor. 

  1. Operational sanctions breaches: regarding the risk of a sanctions violation due to the manner in which the aircraft is operated, as between the lessor and lessee this risk is customarily addressed by means of a negative covenant by the lessee. This covenant often covers the operation by the lessee as well as by any potential sub-lessee. It customarily states that the aircraft may not be operated in breach of any applicable laws and regulations, which is expressly stated to include relevant economic sanctions regimes. It also generally states that the lessee, their officers and directors, and any sub-lessees cannot be a person targeted by economic sanctions.

A breach of such an operating restrictions covenant does not necessarily lead to a termination of the lease arrangement. The effect on the lease very much depends on the scope of the sanctions on the one hand, and the scope of the operations of the lessee on the other. The effects may range from the ban to bring certain spare parts to certain destinations to the cessation of entire operations as in the recent case of Dobrolet. 

Given the long terms of many aircraft leasing arrangements and the parties’ inability to predict whether and what economic sanctions may come into force during the term of the lease, the contractual provisions addressing sanctions are often relatively generic and do not address specific sanctions or sanction regimes.

Considerations for an aircraft lessor when a lessee is sanctioned

If a lessee becomes targeted under economic sanctions, the lessor should look to several lease provisions to determine the contractual effect of the sanctions designation, and possible recourse.

  1. Illegality: if sanctions are imposed on a lessee, this will generally trigger an illegality termination under the lease. A standard illegality clauseprovides that if, as a result of a change in law, it becomes unlawful for the lessor or lessee to give effect to their material obligations under the lease, the lessor may terminate the leasing of the aircraft under the lease by notice in writing to the lessee.

If the aircraft has not yet been delivered, the lessee could argue that this clause does not apply, and only applies to a change in law after the date of the lease. However, the conditions precedent in the lease customarily hinder a delivery of the aircraft to the lessee if such delivery would immediately lead to the breach of a representation or an illegality event.

  1. Costs Indemnity: if the lessor terminates the lease pursuant to the illegality clause, generally a standard costs indemnity in the lease will cover all losses the lessor may sustain as a result of the termination. Recovery of such costs and losses from the lessee could however be restricted by the sanctions. For example, payment by the lessee under the indemnity may be prohibited or may require prior consent from a competent government authority.
  2. Security Deposit: if, pursuant to the lease, the lessee provides a security deposit to the lessor, the lessee could seek to have the deposit returned to it upon termination of the lease. If the lease provides that the security deposit is the sole property of the lessor, this would be of assistance to lessor’s ability to retain the deposit. Otherwise, the lessor may be required under sanctions to block or freeze these funds, on the basis that the lessee retains some “interest” in the funds.
  3. Communication with lessee: if a lessor becomes aware that a lessee has become the subject of sanctions (other than by way of notification by the lessee), the lessor should formally notify the lessee of the position, reserving all the lessor’s rights under the lease documents, including its right to terminate, pending further analysis of the consequences of the sanctions. Any guarantor of the lease should be included in the notice. For aircraft that have not yet been delivered, communications with the airframe manufacturer should also be considered, for example to indicate that the manufacturer should not implement any instructions regarding the aircraft provided by a sanctioned lessee.
  4. Considerations re affiliates of lessee: sanctions against the lessee may not cover the parent of the lessee. On the other hand, sanctions against a parent company will often negatively affect a lease to its subsidiary. This requires detailed case-by-case analysis of the relevant facts and sanctions rules.
  5. Considerations re sub-lessees: if the lessor is aware that the lessee may sub-lease the aircraft to a sanctioned sub-lessee, this could be a breach of the sanctions and the lessor could not consent to the sub-leasing. It could also be a breach of the sanctions if the lessor were to deliver the aircraft to the lessee with knowledge that it will be made available for the benefit of a sanctioned sub-lessee.