With competition among aircraft lessors remaining fierce, airlines are taking an increasing proportion of aircraft on operating leases. The 'wholesaling' of debt financing – where the primary recourse entity on financings is the lessor rather than the airline – is an important recent trend in the aircraft financing market that is likely to continue. This update examines some of the structural items that aircraft financiers should consider in executing operating lessor financings, and the pitfalls that should be avoided.

Lessor recourse and security

Aircraft lessors purchase aircraft and lease them to airlines over time. The aircraft lessor relies on the aircraft lease for its cash flows, and the lease contains detailed maintenance, insurance, information, operational and redelivery provisions so that the lessor can monitor compliance and protect its investment.

The aircraft lease is valuable to the aircraft lessor, but also to banks and financial institutions that provide financing to the aircraft lessor. While under an operating lessor financing, the primary recourse entity is often the aircraft lessor. Financiers usually take security over the lease so that they can enforce the airline's lease obligations at the time of a financing default.

This offers financiers an attractive twin recourse. It means that if the aircraft lessor were to default, it would be possible to enforce the security taken over the lease so that the airline's obligations under the lease were performed directly in favour of the financiers or their security trustee.

Lease provisions

At a minimum, aircraft leases must cover the following bases.

Payment provisions The aircraft lease provides valuable cash flow, and airlines should be required to pay rental and other payments on an unconditional basis, or – as the provisions are known – come "hell or high water". Payments should be made without set-off or counterclaim, and increased if necessary to offset the assessment of withholding taxes. Taxes arising in connection with the lease or the operation of the aircraft should be the responsibility of the airline.

Operational indemnity Lessors and financiers should be indemnified for losses that they incur as a result of the airline's operation of the aircraft.

Asset protection provisions The lease should contain appropriate asset protection provisions that regulate the basis on which the aircraft is operated, modified, subleased and maintained. The airline is required to maintain insurance against the risk of damage or destruction of the aircraft, and against third-party claims made against the lessor or its financiers. Financiers will also want to ensure that subleasing provisions are appropriate – including where a change in the state of registration of the aircraft is contemplated – and that engine and parts pooling and interchanging provisions strike the right balance between operational flexibility for the airline and practical enforcement for the financiers. The extent to which the financing parties have an independent consent right hardwired in the lease for these matters is regularly a negotiation point among the transaction parties.

Monitoring and inspection Financiers will want to know that the provisions requiring the airline to provide financial and certain other information are sufficient, and will want to have an independent right to carry out regular inspections of the aircraft.

Protection of interests Financiers will want to see that the interests of the owner and the financing parties are appropriately registered in all relevant jurisdictions and that the airline will cooperate with any updated or corrected filings that may need to be made.

Where substitute aircraft or replacement leases might be funded under an operating lessor financing, the financing documents will set out these (and other) minimum documentary requirements, or core lease provisions, for the aircraft leases. Where a portfolio of aircraft is financed, the financiers will want to ensure that concentration limits are not breached, and that financial tests are satisfied at the time of the prepayment of individual aircraft and at the time of any re-lease (more on this below).

Because of the importance of the lease, due diligence is essential in order to ensure that it includes no unexpected provisions or omissions, and that the upstream financing arrangements take account of the commercially agreed position set out in the lease. The time allowed for carrying out lease due diligence can be short, so financiers should retain experienced legal counsel in order to ensure that important issues are raised and reflected in the financing documentation.

Lessor obligations under operating leases

In contrast with finance leases, which are economically similar to a loan, aircraft lessors under operating leases have material obligations that they are required to perform. Lessors may be required to:

  • make a contribution towards maintenance costs;
  • make contributions towards the cost of mandatory modifications affecting the aircraft;
  • return any security deposit at the end of the lease term; or
  • make a payment towards inspection costs.

Depending on the aircraft lessor counterparty, security deposits and maintenance reserves payments made by the airline – and possibly also other lessor obligations – may be cash-collateralised in one or more blocked accounts as part of the financing arrangements.

When leasing stops

If an aircraft is returned by an airline or repossessed before the end of the financing term, it is important to agree in the operating lessor financing documentation what should happen. At a minimum:

  • the aircraft must continue to be maintained and insured;
  • aircraft are typically required to be moved to a state of registration such as the United States, the United Kingdom or Ireland; and
  • financing parties must continue to benefit from effective security.

Maintaining the standard

Operating leases record the framework for the future relationship between the aircraft lessor and the airline, but the lease parties will be in regular contact to agree on the scope of maintenance works – possibly the related release of maintenance reserves – as well as amendments, consents or waivers during the term of the lease.

One of the challenges of operating lessor financings is to strike the right balance between flexibility for the aircraft lessor to run its business as it sees fit, and to give financiers an opportunity to have input into decisions which might materially affect their risk exposure or their recourse.

Operating lessor financings usually achieve this by setting out items which expressly require financier approval, and requiring the lessor to apply a prudent standard generally in relation to the aircraft and its dealings with the airline. Financings therefore usually define the standard that is to be applied.

Where special purpose companies own and lease aircraft, financiers typically require the appointment of an aircraft lessor group company as a 'servicer' to manage the lease on its behalf. Operating lessor financings typically include some servicer events, which set out the consequences of a lease servicer insolvency or material breach. These events may require the appointment of a replacement servicer or result in event of default under the financing documents.

Cash flows and swaps

While airlines would not be expected to be responsible for the financing obligations of the lessor or borrower, advance rates under operating lessor financings are usually structured so that the operating lease cash flows are sufficient to fund the lessor or borrower's payment obligations under the related financing (taking into account any equity contribution towards the purchase price made by the lessor or borrower on delivery).

One challenge that commonly arises is that operating leases tend to be fixed-rate transactions, and bank lenders, which constitute a substantial portion of the aircraft financing market, typically prefer to receive interest under loans on a floating rate basis. The interest risk is often hedged by way of a fixed rate swap under International Swaps and Derivatives Association documentation between the borrower and a swap counterparty.

The detailed terms on which the swap is entered into will vary from transaction to transaction, but the financing counterparties will need to decide:

  • whether the swap is secured against the aircraft;
  • where swap payments rank relative to the interests of other financing parties; and
  • the basis on which the swap provider may be entitled – or required – to terminate the swap agreement.

Financiers typically require that the lessor or borrower assumes the risk of a default by the swap provider of its obligations under the swap documentation (and the lessor or borrower would be required to enter into a replacement swap in these circumstances), even if the swap provider is also a lender under the financing. This is partly to achieve syndication – either on financial close or at a later date.

Portfolio considerations

In the context of a pooled aircraft portfolio financing – where changes to the proposed portfolio occur because of the substitution or re-lease of aircraft or otherwise – financiers will want to avoid overexposure to a particular aircraft type, airline or geographic region. In order to do this, concentration limits will typically apply, which set maximum percentages of exposure (based on aircraft appraisals) to each relevant concentration limit category.

Where a new or replacement aircraft is introduced into the financing, a loan-to-value ratio (LTV) test will probably be required. While the events which give rise to a re-testing of the LTV are a negotiation point, it is not uncommon for LTV testing to occur in connection with each borrowing, each disposition of an aircraft, each re-lease of an aircraft and at agreed intervals during the financing term.

Where a new lease (whether for a replacement or an existing aircraft) is entered into, financiers will want to ensure that debt service coverage ratios are still satisfied. Broadly, the debt service coverage ratio is a cash flow test, designed to ensure that expected operating lease cash flows are sufficient to cover scheduled debt service (principal and interest) under the financing. Again, the events which give rise to re-testing are up for negotiation.

Lessors and other business

For syndicated lending transactions relating to designated aircraft or portfolios of aircraft, financiers will want to ensure that the lessor or borrower owns only facility-funded aircraft. The aircraft lessor's obligations under an operating lease to its airline counterparty will be full recourse obligations, and financiers will want to exclude the risk of claims against the lessor or borrower arising as a result of a breach (or a third-party claim) arising in relation to an unrelated, unfunded aircraft. It is also important to remember that lessors under operating leases – in contrast with finance leases – typically owe material obligations to their airline counterparties, which is another reason why financiers would object to lessors or borrowers carrying on other business.


As described above, there are a number of structural items to consider and plenty of traps for the careless. With the operating lease product set to remain popular, operating lessor financings are here to stay. The most successful financings are built on a firm base: an operating lease that accommodates the interests and requirements of financiers, and a financing that considers the negotiated agreement between lessor and airline in the lease. The best outcome for all parties is a financing arrangement that is robust enough to provide certainty in a default scenario but flexible enough to allow lessors and airlines to carry on their business without undue restriction.

This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.