EETCS IN THE DOWNTURN: AN ASSESSMENT
By: Ronald Scheinberg*
I. Introduction.
Aircraft are expensive. They can cost from $18 million for a 50-seat Canadair regional jet to over $150 million for a Boeing 777 aircraft. U.S. airlines have taken delivery of hundreds of jet aircraft in the last ten years. With the limited ability of the bank market to absorb the massive financing requirements of these capital expenditures, the airlines, aided by their investment bank advisers, have been able to turn to the capital markets to satisfy their financing needs. While the capital markets have been tapped for some time to finance aircraft (and rail) equipment, largely in the form of publicly issued equipment notes, the security commonly known as the enhanced equipment trust certificate (EETC) has become the mainstay for the financing in the public markets of aircraft. First issued in 1994, U.S. airlines have issued over $35 billion of EETCs to finance aircraft in their fleets.
The economic downturn that accelerated in 2001, only to be exacerbated by the horrific events of September 11, 2001, has hit the airline sector especially hard. Airline bankruptcies have been occurring, and more may be in the offing. Further, even the largest of the main line carriers have been suffering negative cash burns at unsustainable rates. How the EETC security has performed in this environment, and the prognosis for its future, is the subject matter of this Article.
In this Article, I will first provide a general overview of the EETC security so as to lay the foundation for the analysis that is to follow. Once that foundation is laid, I will explore the case histories of some of the EETCs issued by airlines which have filed, or have come close to filing, for bankruptcy protection. Next, I will discuss some of the things we have been seeing in the EETC secondary markets. Finally, I will provide an assessment of some of the ways EETCs may be improved and prospects for their future.
II. The EETC Structure.
To be sure, this is not the article that will explore all of the nuances and structural technology that is embedded in an EETC. Rather, my intention is to give the reader enough of a structural overview of the EETC so that the reader can follow the discussion in the later parts of this Article.1
Fundamentally, the EETC is a security:
· that relies on the credit of a single corporate issuer. · that is secured by aircraft as collateral.
* Partner, Vedder, Price, Kaufman & Kammholz. © Ronald Scheinberg 2002. The author would like to thank the following individuals for their assistance in drafting this article: Jon Arnason, Robert Gates, James Palen, Joe Shammas, Tom Smith and Evan Wallach. Vedder Price represented America West Airlines in its out-of-court restructuring and represents United Air Lines as special aircraft counsel in its Chapter 11 case.
1 The description contained in this section applies to most EETCs. To be sure, there are deal-by-deal deviations from this description. Such deviations are more frequent in the earlier deals and will be relevant in our later examination of some of the recent case studies.
NEWYORK/#96080.3 · that utilizes a liquidity facility to provide up to 18 months of missed interest payments. · that utilizes structural enhancements to provide improved loan-to-value ratios for the more senior levels, or tranches, of debt securities.
The following diagram (Diagram 1) provides an overview of a typical EETC transaction (with this indicative transaction including a financing done on a prefunded basis with the benefit, at the most senior tranche, of a monoline insurance company wrap; prefunded and wrapped transactions are not universal to every financing) and, by reference to that diagram, I will explore the above-enumerated fundamental
Airline
Lease Rental Payments Assigned by Lessors on Leased Aircraft and Mortgage Payments on Owned Aircraft
Indenture Trustee for Leased Aircraft and Owned Aircraft Series A Series B Series C Series D
Excess Rental Equipment Notes Equipment Notes Equipment Notes Equipment Notes Payments Equipment Note Payments Lessors on all Aircraft Advances and Liquidity for Reimbursements (if ay) Provider Leased Subordination Aircraft Agent Policy Policy Drawings and Provider Principal, Premium (if any) Reimbursements (if any) and Interest Distributions Depositary
Interest Payments on Deposits Pass Through Pass Through Pass Through Pass Through Trustee for Trustee for Trustee for Trustee for Escrow Class A Trust Class B Trust Class C Trust Class D Trust Agent
Holders of Holders of Holders of Holders of Class A Class B Class C Class D Certificates Certificates Certificates Certificates
Diagram 1: EETC Structure
- 2 - NEWYORK/#96080.3 elements.
Single Corporate Issuer
The EETC is fundamentally a secured corporate credit, not a securitization2. The investor takes default risk of a single airline (and not a diversified borrower/lessee base). There are two primary financing structures for EETCs that create the underlying obligation of the airline to make its scheduled payments. The first is a mortgage financing (see Diagram 2). In this type of financing, the airline will issue promissory notes (commonly known as equipment notes) in tranches (in our example, A, B, C and D), with the A note tranche being ranked ahead of the B note tranche, the B note tranche being ranked ahead of the C note tranche, etc. The equipment notes will be secured by one aircraft in the airline’s fleet.
Benefits of Indenture Noteholder Indenture Trustee
Indenture (grant of aircraft mortgage)
A Note B Note C Note D Note
Airline
Aircraft Ownership
Aircraft
Diagram 2: Mortgage Financing Structure
2 A primary difference between the two being that in a secured corporate transaction the special purpose issuer has a lien on the collateral and in a securitization the special purpose issuer owns the collateral.
- 3 - NEWYORK/#96080.3 The second type of underlying financing is a leveraged lease financing (see Diagram 3). In this type of financing, an equity investor, acting through an owner trustee, will purchase an aircraft, borrowing up to 80% of the aircraft cost, with the balance provided by the equity investor. The borrowed funds will be obtained by the issuance by the owner trustee of equipment notes in tranches as described above. The owner trustee will then lease the aircraft to the airline. As collateral for the equipment notes, the owner trustee will grant the equipment note holders a mortgage on the aircraft and assign to the holders the lease. The equipment notes are issued by the owner trustee on a non-recourse basis and will be entirely serviced by the lease cash flows.
Noteholders Benefits of Indenture
Indenture Trustee A Notes B Notes C Notes D Notes
Indenture (grant of mortgage/assignment of Lease)
Owner Owner Manufacturer Title Trustee Trust Participant Agreement
Assignment Lease of Purchase Aircraft Ownership Purchase Contract Lease Rentals Agreement
Airline Aircraft
Diagram 3: Leveraged Lease Financing Structure
- 4 - NEWYORK/#96080.3
An EETC financing may involve as many as 30 or more aircraft. The equipment notes issued with respect to each aircraft will be aggregated and held by a separate pass through trust for each class of notes. Thus, all of the A equipment notes for all of the aircraft in a particular EETC are held by a class A pass through trust, all of the B equipment notes for all of the aircraft are held by a class B pass through trust, etc. (see Diagram 4). Each pass through trust, then, issues pass through certificates to investors. Each investor then can purchase pass through certificates that are issued at either the class A, B, C or D level.
A Note Class A Class A Pass A PTCs Owner Trustee PTC Owner Through (or AIRLINE if B Note Holders Participant Mortgage Financing) Trust
C Note Class B Class B Pass B PTCs Through PTC Holders AIRLINE Rent Aircraft Trust D Note (Leveraged Lease)
Class C Class C Pass A Note C PTCS PTC Through Holders Trust Owner Trustee Owner (or AIRLINE if B Note Participant Class D Mortgage Financing) Class D Pass D PTCs Through PTC C Note Trust Holders
Aircraft DNote
Diagram 4: Equipment Note/Pass Through Trust Structure
- 5 - NEWYORK/#96080.3 Aircraft as Collateral; §1110
Aircraft as collateral possesses many positive features. First, it is big ticket; to execute an economically sized financing, you don’t need very many of them. That is important if you need to chase them down (repossess) in a problem situation. Second, they have historically retained their value; they depreciate in value over time in ways that have been relatively predictable. Third, they are relatively liquid; there has historically been a vibrant secondary market for them. Fourth, they are easy to track; they are hard to hide, and, if in service, national aviation authorities will likely know where they are. Fifth, they are mobile assets, making them physically easy to repossess, store and relocate. And sixth, they have the protections under §1110 of the Bankruptcy Code3.
Simply put, §1110 of the Bankruptcy Code provides that within 60 days after a qualifying air carrier files a petition seeking reorganization under Chapter 11 of the U.S. Bankruptcy Code, that air carrier must agree to continue to perform its obligations under the relevant aircraft lease or mortgage and cure any defaults, or, at the request of the aircraft financier, return the aircraft to it. Accordingly, aircraft financiers, unlike most other lenders or lessors to an entity which has filed for Chapter 11 protection, have the assurance that if the airline is not performing its obligations under the relevant financing documents, they may obtain possession of their collateral within a limited period of time. The spectre of valuable collateral being tied up for a lengthy period of time in a bankruptcy proceeding while it depreciates in value is of course frightening to investors, particularly those from countries which have a more creditor- friendly bankruptcy system. This special protection, then, constitutes one of the linchpins of EETC, and indeed all U.S. aircraft, financings.
Liquidity Facility
Each class of pass through certificates in an EETC usually has issued for its benefit the additional protection of what is commonly known as a liquidity facility. Liquidity facilities are, typically, revolving credit facilities made available by highly rated financial institutions that will cover the timely payment of expected interest (not principal) distributions to the pass through certificate holders if the airline issuer has failed to make a payment in full.4 These interest (only) distributions cover 18 months’ of interest (in a standard semiannual-pay transaction, the equivalent of three interest payments). Why 18 months? The rating agencies have assumed that 18 months is a period sufficient to recover the aircraft collateral following a default by the airline and to liquidate it in an orderly fashion so (the theory goes) as to recover the principal component of the investment in the pass through trust certificates. This 18 month time- frame makes sense in the EETC context only because the aircraft have the benefit of §1110 of the Bankruptcy Code; the financier is assured of, at worst, return of its collateral within 60 days of an airline bankruptcy.5
3 11 U.S.C. §1110. In order to qualify for §1110 protection, the subject aircraft must satisfy modest size requirements (all jet aircraft that could conceivably be subject to an EETC financing would meet these requirements) and, if placed into service prior to October 22, 1994, must be subject to either a lease financing or a mortgage financing that constitutes purchase money indebtedness (i.e., the financing must have been supplied in order for the airline to acquire the aircraft).
4 The liquidity facility can also take the form of a letter of credit or other stand-by facility with similar characteristics to a revolving credit facility.
5 If an airline does not file bankruptcy protection, the recovery of the aircraft collateral following a default is relatively straightforward and can usually be accomplished in less than 60 days.
- 6 - NEWYORK/#96080.3 The financial institution acting as liquidity provider earns a standby commitment fee for its undrawn “standby” obligation and interest on any drawn payments, and obtains a super-priority position on the proceeds of collateral liquidations (which explains why liquidity facilities are not very expensive facilities). The liquidity provider becomes the controlling party (more on which below) should it not be reimbursed within 18 months after the earlier of (x) the date it has been fully drawn and not reimbursed and (y) the acceleration of all related equipment notes. Amounts drawn under a liquidity facility in respect of interest drawings are subject to reinstatement from subsequent cures by the airline or cures made by an equity investor (or receipt of other proceeds of collateral) unless a “liquidity event of default”6 is continuing. Following a liquidity event of default, if less than 65% of the aggregate outstanding principal amount of all equipment notes are performing, the liquidity provider can cause a final drawing under the liquidity facility (which effectively liquidates the liquidity provider’s claims at that point and enables it to apply the first monies in on collateral liquidation to such claim).
Structural Enhancements
As noted, EETCs are tranched, that is, issued in classes of securities, with the more senior tranches have a first claim on the collateral and enjoying enhanced over-collateralization. The improvements in loan-to-value (LTV) coverage provide a significant ratings boost to these securities when compared to the airline’s senior secured rating and delivers an overall lower cost of funds to the airline issuer. To be sure, the increase in the credit rating of the senior classes is achieved at the expense of the lower rated classes; the more junior classes of debt suffering greater risk of first loss. Thus, in a default situation,7 the most senior tranche (after giving effect to, among other things, the liquidity provider’s and indenture trustee’s reimbursements requirements) receives all proceeds from the liquidation of collateral before there is any distribution to the next junior pass through certificate holders.8 This feature is commonly referred to as cross-subordination, which for the more senior tranches,
6 Acceleration of the equipment notes or bankruptcy of airline issuer.
7 That is, following a “Triggering Event”, which is commonly defined as the occurrence of either (i) a payment default under all indentures resulting in a payment default in respect of the most senior class of pass through trust certificates, (ii) acceleration of all equipment notes or (iii) events of bankruptcy relating to the airline issuer. Given the importance of the “Triggering Event” definition (see discussion in the next footnote), it is important for secondary market investors to verify just how this term is defined in any particular deal.
8 This statement is an oversimplification but, given depressed aircraft values, is not far from the reality of the current situation. If there is some incoming cash flow on the EETCs following a triggering event (payments on non-rejected “performing” aircraft), the most senior tranche is entitled to absolute priority in payment only until a predetermined LTV ratio is restored; once restored, the next junior tranche is entitled to principal amortization until its predetermined LTV ratio is restored, etc. Alternatively, if there is a liquidation of aircraft or equipment notes, or lease income following a triggering event if all of the equipment notes issued in respect of any aircraft are “non- performing”, the proceeds of such distribution will be applied to the most senior tranches on an absolute priority basis, regardless of the predetermined LTV ratio. Distributions on this basis are described as being made on the basis of “adjusted expected distributions” (versus “expected distributions”; which are the distributions (normal debt service) that are expected to be made on a scheduled basis). In point of fact, the adjusted expected distribution formula moves toward absolute priority for full principal balance as the equipment notes for any EETC become non- performing and as the assumed LTV of a tranche exceeds target LTV on a current market basis.
- 7 - NEWYORK/#96080.3 effectively amounts to cross-collateralization (that is, being able to apply proceeds from the disposition of any aircraft first to the most senior pass through certificates).9
The structure of an EETC dictates that in a default situation, the holders of a majority of the most senior outstanding pass through trust certificates will be the controlling party. The controlling party will be the party that will control decisions regarding the exercise of remedies. These include:
(i) directing the subordination agent to sell the defaulted equipment notes;
(ii) instructing the loan trustee under the applicable indenture to accelerate the related equipment notes;
(iii) directing the foreclosure on and/or third party sale of the related aircraft; and
(iv) directing the leasing of the related aircraft, including back to the defaulting airline.
Since the controlling party’s interests are not identical to those of the more junior tranches, the controlling party’s rights are subject to the following constraints during the nine-month period following the earlier of acceleration of the equipment notes or bankruptcy of the airline:
· the underlying equipment notes may not be sold for a price less than the lesser of (x) the balance of such equipment notes and accrued interest thereon and (y) 75% of the appraised current fair market value of the aircraft.10 · an aircraft may not be sold for a price less than the lesser of (x) the balance of such equipment notes and accrued interest thereon and (y) 75% of the appraised current fair market value of the aircraft. · in the case of any leased aircraft, the lease rentals may not be adjusted if the discounted present value of the adjusted rentals (discounted at the weighted average interest rate of the equipment notes) would be less than 75% of the discounted present value of the unadjusted rentals; both calculations being based on the entire term of the new and the old lease.
An interesting, and perhaps troubling, feature of this cross-subordination is that there are situations where the holders of the more junior classes of pass through certificates may be in a position vis a vis the airline worse than the holder of the airline’s unsecured debt. Whereas the holder of a bankrupt airline’s unsecured debt may receive pennies on the dollar (or equity in the reorganized airline), the holders of the more junior tranches of pass through certificates may have absolutely no claim at all. For example, if the controlling party were to sell all of the equipment notes in an EETC for, say, 60% of the outstanding principal balance of the equipment notes, the proceeds of such sale would, as per the waterfall, be applied to the more senior tranches leaving little, if anything, for the holders of class D certificates since the equipment notes represent the “direct” claim against the airline. Once they have
9 It is important to note that the equipment notes themselves are not cross-collateralized. Thus proceeds from the sale of an aircraft in excess of the amounts due on equipment notes related to that aircraft will not be available to cover any losses on equipment notes issued in respect of other aircraft.
10 There are a limited number of EETCs (four by our count) that do not have any test at all for sales of the underlying equipment notes.
- 8 - NEWYORK/#96080.3 been sold, the class D holders (in my example) have a claim only against the class D pass through trust which now has no assets.
As a further level of protection for the junior certificate holders, the intercreditor agreement grants to them in default situations the right to buy-out the more senior tranched pass through certificates, thereby allowing them to become the controlling party and, for example, to delay what they may perceive as a precipitous sale of the aircraft collateral. Of course, this could be a rather expensive course of action and would be unlikely if it would require expending large sums of money.11 However, this may be an appropriate course of action if the class A tranche has been greatly paid down by virtue of a partial liquidation of aircraft in the EETC.12
Certain Other Features
To close out this discussion on the EETC structure, it is worth mentioning two further features that are not uncommon and are reflected in Diagram 1.
First, is the inclusion of a depositary into which cash received from pre-funding an EETC is deposited. Airlines have utilized this feature to lock-in financing for aircraft that are to be delivered in the relatively near future (usually no more than nine months following the date of issuance). The prefunded monies remain with the depositary until the aircraft is delivered from the manufacturer and are disbursed upon delivery of the aircraft to purchase the debt associated with the mortgage or leveraged lease financing. While the prefunded monies sit with the depositary, the depositary institution agrees to pay the certificate holders interest at their respective interest rates, invests these monies in deposits with such institution at an agreed rate (usually based relative to LIBOR) and receives from the airline the negative carry interest charges.13 Importantly, these prefunded monies sitting with the depositary are not construed as assets of the airline issuer, and therefore are neither subject to attachment by a creditor of the airline nor part of its estate following a bankruptcy filing.
The second relatively common feature is the “wrapping” of the most senior tranche of the EETC issue by a AAA-rated mono-line insurer. The wrapping of the most senior tranche is akin to its guarantee by the insurer. As the price for such credit support and so long as the insurer is performing its obligations, the holders of the class A tranche will cede to the insurer their rights as controlling party.
III. Case Histories
The ongoing difficulties facing the United States airline industry make this assessment of the EETC in the current economic downtown a work-in-progress. As of the date of this writing, Midway Airlines filed for Chapter 11 and, for practical purposes, has been liquidated, America West averted bankruptcy by restructuring certain of its obligations in an out-of-court work-out and both USAirways and United Air Lines are currently debtors in Chapter 11 proceedings. I will review below some interesting developments in connection with the EETCs these airlines have issued.
11 It is hard to imagine a credit committee for an institutional holder holding, say, $10,000,000 of class B certificates to authorize the expenditure of an amount equal to the balance of the class A certificates (that may be many multiples times such holder’s balance).
12 The junior certificate holders can also participate in any sale of the collateral if they feel the price is too low.
13 The coupon rate less the investment rate on the deposit.
- 9 - NEWYORK/#96080.3 1. America West.
In the fall of 2001, America West was facing a severe liquidity crisis. The airline declared a “moratorium” on its operating leases and certain other financing obligations in order to preserve cash. America West’s “end game” was to preserve its liquidity until it could get a sizable loan guaranteed, in part, by the U.S. government acting through the Air Transportation Safety Board (created in the wake of the events of September 11th) and restructure its aircraft fleet operating leases in an out-of- bankruptcy restructuring. Importantly, for the purpose of this analysis, America West determined not to try to restructure any of its EETC obligations. As is the case with most arduous endeavors, getting the ATSB loan took longer than expected. While America West obtained conditional approval for the ATSB loan in December 2001, it took longer than expected to finalize arrangements with the ATSB and the other investors who were coming to the airline’s rescue. With a January 2, 2002 payment on their EETCs passing by, America West had to forgo making that payment. As provided for in the EETC structure, there was an immediate drawing on the liquidity facilities to make interest payments for all of the EETCs that were required to pay interest on such date and the liquidity providers performed as required. To make a long story short, after having blown through the ten business day grace periods under the indentures covering the aircraft in the EETCs (without the controlling party under any EETC having taken any remedial action), America West obtained their ATSB loan, brought current the past due EETCs and made whole the liquidity providers.
2. Midway Airlines.
Midway Airlines was the issuer under two EETCs:
· Midway 1998-1 secured by 8 CRJ-200 aircraft · Midway 2001-1 secured by 8 Boeing 737-700 aircraft (7 delivered)
Midway filed for Chapter 11 bankruptcy protection on August 13, 2001. The airline returned all of the EETC – financed aircraft prior to the end of the §1110 60-day period. The aircraft under the 1998-1 EETC were financed by leveraged lease financings; four with General Electric Capital Corporation (GECC) as the equity investor and four with Verizon Capital as the equity investor. GECC exercised its buy-out rights under the leveraged leases and the proceeds of the buy-out were applied under the EETC waterfall to the class A pass through certificate holders. Since the balance outstanding on the class A pass through certificates was now relatively small, the class B holders exercised their buy-out rights, thereby becoming the controlling party under that EETC. On the balance of the EETCs pass through certificates, a private sale of the equipment notes was orchestrated, with the most junior tranches of the EETCs (class Cs and Ds) suffering a significant loss.
The aircraft under the 2001-1 EETC were also financed by leveraged lease financings, all with GECC as the equity investor. The aircraft were prefunded under the EETC. At the time of the bankruptcy, all but one had been delivered. The eighth aircraft’s prefunded monies were returned to the certificate holders (the airline not claiming that those monies were property of the estate) and GECC paid off the debt (and expenses) on the seven funded aircraft, leaving the certificate holders whole without a loss.
3. USAirways.
USAirways is the issuer under seven EETC financings covering 115 aircraft, all but one of which, USAirways 1996-1, cover Airbus aircraft. USAirways filed for bankruptcy on August 11, 2002. As part of their plan to emerge from bankruptcy, USAirways announced their intention to evolve into an all Airbus fleet. Accordingly, only the aircraft subject to the USAirways 1996-1 EETC were
- 10 - NEWYORK/#96080.3 rejected (constituting nine Boeing 757 aircraft).14 These aircraft were financed by the direct issuance by USAirways of three tranches of equipment notes, secured by mortgages on the aircraft, rather than using the pass through structure described above. The controlling party under the 1996-1 EETC (the A equipment note holders) is currently negotiating to keep these Boeing aircraft with USAirways on a six year operating lease basis. By virtue of the cross-collateralization of these equipment notes, all proceeds of these rentals will be allocated exclusively to the liquidity provider and the class A equipment note holders (sequentially, in that order). Once the 18-month liquidity facilities are exhausted, it is anticipated that the class A note holders will (as they are entitled to do under the intercreditor arrangements for this transaction) tender their notes in exchange for ownership in the aircraft, thereby wiping out the holders of the B and C equipment notes. Insofar as these were mortgage-financed aircraft, there are no limitations on the rights of the controlling party to lease the aircraft to USAirways, or anyone else. As a consequence of this leasing transaction, Standard & Poor’s lowered the ratings on the B and C tranches of this EETC to CCC and D, respectively, because of the “little chance of eventual full repayment” on these notes.15
4. United Air Lines.
United Air Lines (UAL) filed for Chapter 11 bankruptcy protection on December 9, 2002. As this Article is going to press, UAL is within the 60-day § 1110 window constituting the period in which it must elect either to reject any particular aircraft financing (and return the applicable aircraft) or to agree to perform its obligations under such financings, such window closing on February 6, 2003. Given a fleet of approximately 470 aircraft subject to financing, it is likely that on or before February 6, 2003 UAL will take the following actions:
· for aircraft critical to its fleet plan (and where such aircraft’s fair market value is in excess of the outstanding debt/indebtedness thereon), agree to perform on the related aircraft financings
· for aircraft that clearly do not fit within its fleet plan, reject the financings in respect of those aircraft and return such aircraft to the financiers thereof
· for aircraft that are desirable for the airline, but at reduced financing rates, unless UAL has been able to cut its new deal with the financiers thereof prior to such date, seek to obtain an extension of that date with the approval of the related financiers so as to have more time to cut the a mutually agreeable deal.
UAL is the issuer under four EETCs, summarized as follows:
14 Actually, the 1996-1 EETC was an issuance of enhanced equipment notes. The 1989-A pass through trust financing of Boeing 737 aircraft is not included in this analysis because they had no liquidity feature, although they were done on a pass through trust basis.
15 Standard & Poor’s Report dated November 26, 2002: “Selected USAirways Inc. Ratings Lowered”.
It is worth noting that this particular EETC is not a typical EETC issuance. The primary difference being that class A noteholders are entitled to repayment in full before any amortization could be applied to the junior holders (versus the more traditional structure noted above that the senior noteholders are entitled to accelerated principal repayment until a predetermined LTV is attained; once that LTV is achieved, the junior tranches are entitled to principal amortization as well).
- 11 - NEWYORK/#96080.3 · 1997-1, issued in two tranches (A and B), secured by Boeing 747-400 aircraft (2), Airbus A320-200 aircraft (4), Boeing 777-200 aircraft (3), Boeing 777-200ER aircraft (1) and Boeing 737-300 aircraft (4)
· 2000-1, issued in five tranches (A-1, A-2, B, C-1 and C-2), secured by Airbus A320-200 aircraft (6), Boeing 747-400 aircraft (1), Boeing 757- 200 aircraft (7), Boeing 767-300ER aircraft (2) and Boeing 777-200ER aircraft (4)2000-2, issued in four tranches (A-1, A-2, B and C), secured by Boeing 757-200 aircraft (7), Boeing 777-200ER aircraft (9), Boeing 747-400 aircraft (3), Airbus A320-200 aircraft (6) and Airbus A319-100 aircraft (12)
· 2001-1, issued in six tranches (A-1, A-2, A-3, B, C and D), secured by Airbus A319-100 aircraft (10), Airbus A320-300 aircraft (6), Boeing 747-400 aircraft (5), Boeing 767-300ER aircraft (5) and Boeing 777- 200ER aircraft (4).
The wide variety of aircraft in each of these EETCs would indicate that, in the near term, such aircraft will be subject to a combination of the results spelled out above.
5. General Observations.
Generalizations are oftentimes dangerous to make but in the scope of aircraft finance for the U.S. majors, there really are only two worlds the financier must face in respect of its airline issuer: out of bankruptcy or in bankruptcy. While out of bankruptcy, EETCs financiers are usually safe from pressures to renegotiate economic terms of the financing given the difficulties of obtaining unanimous consent from the holders of the EETCs for such concessions.
In a bankruptcy situation, EETC financiers may face one of three situations:
· rejection/return of aircraft [aircraft collateral does not fit into the carrier’s fleet plan] · affirmation of aircraft financings [aircraft are critical to carrier’s fleet plan] · carrier seeks to renegotiate contract terms under threat of return.16
The fleet plan needs of a carrier in bankruptcy are highly secret and the bankrupt carrier will often play on the fears of aircraft financiers of an aircraft return to obtain concessions. In an EETC context, three observations may be made:
· first, the game of chicken a carrier may want to play with EETC investors may be impossible to manage if the controlling party is a
16 It must be noted and emphasized that §1110 has not provided the kind of protection that many financiers thought it would because it does not trump the aircraft market. If the debtor airline is only prepared to pay 50% of the contract lease rate and that represents the market rate, invoking §1110 rights and taking back the aircraft may be a poor economic decision for the aircraft financier. As has been demonstrated by current or recent Chapter 11 cases of National Airlines, USAirways and UAL, lenders and lessors have preferred to leave their aircraft with the debtor airline at reduced lease or loan rates rather than take them back, incur the expense associated therewith, and run the risk that the aircraft may sit in the desert for a considerable period of time.
- 12 - NEWYORK/#96080.3 diffuse group of investors. If the aircraft in question are critical to the airline’s fleet plan, then the airline will likely err on the side of affirmation of the financing rather than rejecting the financing with the hope/expectation of a renegotiated financing but risk of no accommodation. · second, for aircraft that are on the cusp of being required for the fleet plan (for example, the airline needs only 30 of the 60 Boeing 737-300 aircraft it has), the airline will likely play chicken with all holders of indebtedness of the affected aircraft type and require those investors to respond quickly to any offer of renegotiated financial terms. In this instance, EETC holders may be at a disadvantage insofar as it may take them longer to coalesce with a response to the airline. · Third, the bankrupt carrier can strike a deal with the controlling party/senior tranche holders that can effectively wipe out the junior tranches, if not immediately, then after nine months’ time.
IV. The Secondary Market
EETC securities are often registered with the Securities and Exchange Commission making these registered securities freely tradable in the open securities market. Those EETC securities that are not registered also trade in the secondary markets. The liquidity of EETC securities coupled with their relative uniformity of structure has enhanced their acceptance in the market. In today’s highly stressed airline market, this capital market instrument has been the subject of much market activity.
1. Sell Side.
A number of EETC investors are ratings driven. That is to say, they are required by either external or internal constraints to buy (and hold) only those securities having a certain minimum credit rating. With the airline economic downturn, these investors have been unloading their EETC holdings as ratings on these securities have declined. Further, investors appear to be selling their EETC holdings to abandon:
· the airline sector [general sector management, fear of consequences of (another) war with Iraq] · particular airlines ·· those that are bankrupt ·· those that may go bankrupt ··· near term ··· intermediate term ··· long-term (all but Southwest/JetBlue?) · EETCs with aircraft perceived to be of less value in general and therefore more likely to be abandoned or rejected by the airline ·· generally ·· subordinate tranches that are underwater and/or lack control
2. Buy Side.
For every EETC sold in the secondary market there is of course, a buyer. Buyers in these difficult times are betting on one or more of the following plays:
- 13 - NEWYORK/#96080.3 · No bankruptcy filing by the airline issuer17 ·· lock in high yields
· Likely bankruptcy filing by the airline issuer ·· aircraft are likely to be retained by airline as part of its reorganization [airline will affirm under §1110]18 ·· aircraft likely to be rejected or abandoned by airline at current lease/loan rates ··· can negotiate a profitable restructuring with airline at lower lease/loan rates ··· can take back aircraft and dispose of aircraft on a lease/sale basis in the secondary aircraft market · Special Situations such as ·· realize on value of liquidity facility ·· equity investor to exercise buy-out right or achieve favorable disposition19 ·· force buy-out by other investors for hold-up value ·· more junior tranches have an incentive to buy-out.
Importantly, when an investor is assessing a purchase of EETC securities where it will have to be active in, e.g., negotiating with the airline or taking control of the aircraft for disposition, etc. for its investment to pay-off, it is critical for such investor to be able to control the exercise of remedies. It is also critical that the investor have the knowledge and resources to properly deal with an expensive asset in a specialized market.
The question of control will require some analysis, especially if the investor is not purchasing a majority of the controlling tranche. Without holding a majority, the investor will need to team-up with
17 In the recent past, we have seen that U.S. airlines prior to a bankruptcy have not attempted to restructure (obtain concessions on) the indebtedness held by EETC investors as part of their public EETC issuances (importantly, noting the distinction that they will approach individual investors who hold entire tranches of a EETC as part of a financing program such investors have signed up with an airline; to wit, Kreditanstalt fur Wiederaufbau with United Air Lines); this was America West’s approach and was the approach of USAirways and United prior to their bankruptcy filings and originates from the fact that 100% of the investors need to agree to any change in the debt held by them [good luck, if you can find them!]. Accordingly, EETC investors are free from the strong-arming to make concessions that take place prior to a bankruptcy between an airline and its creditors.
18 This will require an analysis of the bankrupt airline’s fleet needs, to determine which of its aircraft are disposable, and is a gamble on whether even perceived “non-rejectable” aircraft in its fleet will be rejected as part of game of chicken. A gamble by an A tranche investor who purchases at a discount may yield sizable returns if even a handful of the airline’s aircraft in a particular EETC portfolio are not subject to rejection.
19 Whether there is an equity investor with the wherewithal and/or incentives to take care (by means of a buy-out or lease placement, for example) of the underlying debt is surely a fortuitous event for a current holder. Equity investors in leveraged leases are never identified by name in prospectuses. If their identities are known, not only is there no assurance that they themselves will not sell their equity interests, but also it is most difficult to even guess what their intentions might be. Further, in a prefunded EETC, an investor does not even know whether the underlying financing will be effected as a leveraged lease or a mortgage financing.
- 14 - NEWYORK/#96080.3 others in that class to create a directing majority. The teaming-up option is not necessarily easy.20 First, it is difficult to identify who the other holders are. While it may be common knowledge who owns what (investment bankers may be very helpful here), only the trustee knows the identities of the holders with certainty. Unfortunately, the pass through trustees have not been willing to share the investor lists (requiring all communication to go through it). Second, any potential teammates need to have goals consistent with those of the investor. Third, it would be preferable for any potential teammates to be large institutions rather than a bevy of doctors and dentists.
Finally, as a controlling party in a transaction where an aircraft has been returned by the airline, one will be saddled with the costs of maintenance, storage, insurance and remarketing while the aircraft are sitting in the desert. Further, additional significant costs may be suffered when assuming the burden of converting the repossessed aircraft to a new operator’s requirements.
V. Future Prognosis and Structural Improvement Possibilities
The near-to-medium term outlook for new issuances of EETCs is grim, if for no other reason than that aircraft deliveries will be down significantly over the next three years. Quite a number of U.S. majors will be taking absolutely no new aircraft deliveries in 2003 and 2004, thus there will be relatively few new aircraft to finance. Airlines may continue to try to use EETCs in the near term to finance §1110-qualified aircraft and parts in their fleet as a source of cash liquidity going forward.
Given the need for economies of scale for the EETC, the one-off new aircraft will likely be financed in either the bank or operating lease market. Of course the low fare carriers such as Southwest Airlines and JetBlue will keep up their stream of deliveries, providing one of the few bright spots in the EETC and airline financing market generally. In addition, the U.S. regional carriers are expanding rapidly in the current market, taking on large numbers of regional jet aircraft that may be amenable to EETC financing.
In the longer term, the EETC market will likely open up to non-U.S. airlines with the advent of the UNIDROIT Convention on International Interests in Mobile Equipment. This international convention21, when adopted by any particular country, will, among other things, provide §1110 equivalent protection for aircraft financiers financing aircraft to an air carrier in that country. As discussed above, the protection afforded aircraft financiers by §1110: the right to return of its aircraft collateral if the bankrupt airline does not cure defaults and agree to perform as per the financing documents in the future, is a critical linchpin in EETC financings. Having an equivalent legal assurance in jurisdictions outside the U.S. will greatly expand the number of possible EETC issuers.
In assessing the prognosis for the future, we have, in the preceding two paragraphs, examined the quantity of aircraft that could be subject to financing by EETCs and the possible identities of EETC issuers. What remains to be examined is whether there will be investors willing to buy EETC securities. I think it safe to say that the investors suffering the most in the EETCs (and, to be sure, those that are at most risk of suffering) are the holders of the subordinated tranches. Insofar as creation of tranches in the EETC provides the necessary ability to cross-subordinate and therefore enhance collateral coverage of the
20 The expression “herding cats” comes to mind.
21 This Convention was adopted on November 16, 2001 by a diplomatic conference meeting in Cape Town, South Africa.
- 15 - NEWYORK/#96080.3 more senior tranches, losing the subordinate tranche investor base would surely harm the viability of future issuances of EETCs.22
The EETC subordinated tranche investor that has either seen his investment disappear, or is fearful that, given the controlling party’s powers, such investment will disappear, is likely scratching his head wondering how all this has happened. After all, the valuations he relied on in the EETC’s offering memorandum/prospectus, even at his subordinated level, showed significant loan-to-value cushions and he was relying on an orderly liquidation of the aircraft collateral, over a period of up to 18 months, mirroring the 18 month liquidity facility his subordinated tranche had the benefit of.
In order to bring back the subordinate EETC investor, let us review the particulars of the EETC structure that have caused (or have the potential to cause) the subordinated EETC holder to suffer, and potential structural “fixes” that may bring them back:
1. Precipitous Exercise of Remedies by Controlling Party.
The controlling party under an EETC has, as remedies following an airline bankruptcy or other default, the power to
· sell the underlying equipment notes · sell the aircraft · lease the aircraft
i. Appraisal Issues
I have noted above the 75% tests for the first nine months applicable to each such remedy. As you will recall, the constraint on the two sale remedies is 75% of current fair market value of the aircraft. Insofar as the controlling party is empowered to choose the appraiser that is to assess current fair market value (and then has an additional cushion of 25%), this constraint is rather weak; an accommodating appraiser will likely always be available to furnish an appraisal which will allow the controlling party to sell the aircraft or the equipment notes at a sale price that best covers its exposure.
Possible Solution:
· Remove controlling party’s ability to “shop” the appraisal. Alternatively, allow the junior certificate holders to also choose an appraiser, and average the value determined by the senior certificate holder’s choice with the value determined by their choice.
ii. Aircraft Sale Remedy
To be sure, this remedy is the natural remedy in an aircraft financing. However, the controlling party has no incentive to maximize the sale proceeds so as to provide proceeds coverage for the more subordinated debt holders. In fact, the controlling party has a strong incentive to take the first offer that will cover its exposure. That being the case, the EETC’s underlying presumption of up to an 18-month
22 For the purposes of this article, I am not assuming that the aircraft and engine manufacturers will fill the breach. Nevertheless, they may be the subordinated investors of last resort.
- 16 - NEWYORK/#96080.3 orderly liquidation period (as evidenced by the 18 month liquidity facility) really is not the case for the holders of the subordinated debt.
Possible Solution:
· Provide limited period (nine months?) where the 75% test is to be benchmarked to anticipated aircraft values determined at the onset of the financing; not current fair market values.
iii. Equipment Notes Sale Remedy
It has been noted already that the holders of subordinated tranches may be worse off than unsecured creditors if the controlling party exercises the available remedy of selling the underlying equipment notes, rather than the aircraft.
This writer has a visceral distaste for the equipment note sale remedy. The basis for this distaste is the potential for financial engineering by the controlling party to dispose of the equipment notes, rather than the aircraft, in a manner that unduly prejudices the subordinated tranches. After all, the underlying premise of the EETC is realization on the aircraft, not the equipment notes.
Possible Solution:
· Prohibit controlling party from exercising this remedy altogether, or, at least, for the first nine months unless sale proceeds are enough to satisfy amounts due on all pass through trust certificates.
iv. Aircraft Leasing Remedy
Having an aircraft returned in an airline’s bankruptcy is likely to be a frightening prospect for an aircraft financier, especially in a down market where there are limited sale prospects for aircraft. After all, even putting aside the concerns (and perhaps dim prospects) of selling the aircraft collateral, associated with the return of an aircraft are obligations to store, maintain and insure the aircraft, as well as numerous other costs. What better prospect, then, is there than to keep the aircraft with the airline issuer at a reduced lease/loan rate. Typically, the controlling party may attempt to lease the aircraft to the airline at a negotiated rental rate that usually approximates some current market rate. In an EETC, the controlling party could then assure itself of cash flow that can service at least part of its debt. The controlling party, while wanting to maximize lease rentals for its own benefit, will not be concerned with maximizing lease rentals for the holders of the subordinated classes, who, in any event, will not likely receive any proceeds of lease rentals as they will be sucked up at the highest levels of the waterfall; the senior tranche will collect all rentals until its adjusted expected distributions are achieved – likely a rather high target of collections, especially in light of the need to satisfy current interest requirements (whether directly or for the benefit of the liquidity provider). Interestingly, as noted earlier, during the first nine months following an airline bankruptcy, the standard EETC will not permit the controlling party to lease the aircraft to the bankrupt airline (or any airline, for that matter) at lease rental rates that are less than 75% of the net present value of the (leveraged) lease rental payments over the entire term of the leveraged lease theretofore in place with the airline. Strangely, this limiting-type restriction only applies if the underlying financing was financed pursuant to a leveraged lease; surely, a fortuity as far as the EETC
- 17 - NEWYORK/#96080.3 investor is concerned.23 Further this 75% test may even constrain the controlling party from entering into a short-term lease.
The leasing of an aircraft back to the bankrupt airlines may not be per se fair to the subordinated tranche EETC investor for the following reasons:
· the premise of an “orderly liquidation” of collateral over an 18-month period really does not contemplate a leasing of the aircraft. · a lease of the aircraft may, effectively, wipe out the claim of the subordinated tranche holders given the quite possible result that money from the rentals will never reach them; equity investors in U.S. leveraged leases, who are arguably the most junior of creditors, do not allow this result; they are protected by the “equity squeeze” provision that requires the lenders to dispossess the airline of the aircraft before foreclosing then out.
Nevertheless, the leasing of an aircraft following rejection may very well be the short-term best use of the aircraft. Having the aircraft earning rentals that may help service debt of the most senior certificate holders (and remove accumulated shortfalls above the more junior level of certificate holders) and not having to come out-of-pocket for maintenance, storage and insurance costs, benefits all parties.
Possible Solutions:
· Remove the 75% test altogether. · Require lease terms to be at fair market value and for lease terms not in excess of five years. · Require lease rentals to be applied on an “expected distribution” basis rather than on an “adjusted distribution basis”. · Restrict re-leasing to issuing airline for first nine months at fair market value.
2. Precipitous Application of Adjusted Expected Distributions Waterfall.
As an historical observation, the aircraft subject to EETC financings have been of superior quality; hardly any such aircraft, even in these times of economic downturn, have found their way parked in the desert. Accordingly, EETC investors may be please to find that their aircraft will be affirmed by a bankrupt carrier within the 60-day §1110 period. As affirmed, the bankrupt carrier will be obligated to perform on the underlying financing and cash flow to the EETC pass through certificate holders may (depending on the percentage of aircraft financings in the applicable EETC subject to affirmation) continue unabated. However, the bankruptcy of the airline issuer will be a “triggering event” that will result in the cash flow being distributed on an “adjusted expected distribution” basis.24 On such a basis, all cash flow distribution will likely be absorbed at the upper reaches of the distribution waterfall until predetermined LTV ratios are restored, leaving the subordinated holders without distributions, even though the airline issuer is current on all or a part of the aircraft financing.
23 There does not appear to be any particular logic to having this right available to one set of EETC holders but not to another.
24 See discussions in footnotes 6 and 7 above.
- 18 - NEWYORK/#96080.3 Possible Solution:
· If a bankrupt airline issuer affirms, say, 2/3rds of the underlying financings of an EETC, affirmed financing cash flow should be applied on an expected distribution basis.
Additionally, insofar as “adjusted expected distributions” that result from the triggering event will force distributions to inure to the benefit of the most senior certificate holders until the predetermined LTVs are restored, the determination of current fair market values of the aircraft collateral by the controlling party will have a notable effect on when distributions will filter down to the lower levels of the waterfall.
Possible Solution:
·Protect subordinated holders from manipulated current fair market valuations of aircraft by adopting some of the protections described in “Appraisal Issues” above.
3. Offering Memoranda Appraisals.
The offering memorandum/prospectus delivered to investors in your typical EETC shows loan to value analyses based on appraisals that are determined on the basis of “base value”. Usage of “base value” appraisals at the outset of the transaction that assume “an open, unrestricted, stable market environment with a reasonable balance of supply and demand” and “presumes… an absence of duress and with a reasonable period of time available for marketing” may be of limited utility given that this valuation does not reflect the realities of controlling party action and the state of the market in economic down-turns.
Possible Solution:
· Use fair market value (or distress value) appraisals on EETC issuance and/or provide guidance to investors on how those values can be stressed.
4. Lack of Cross-Collateralization.
In the typical EETC, each individual aircraft is financed on the basis of its own documentation; that is, a separate lease or mortgage for each aircraft. This has two negative results:
· any excess proceeds on the sale of a particular aircraft escape to the airline or equity investors, and do not inure to the benefit of the certificate holders in respect of other aircraft in the EETC pool where there were shortfalls from application on disposition proceeds to the applicable equipment notes. · an airline may return some aircraft in an EETC while not violating their §1110 obligations with respect to other aircraft in the EETC which it retains.
Possible Solutions:
·Require cross-collateralization of all aircraft in a particular EETC. Cross- collateralization will avoid leakage of excess foreclosure proceeds and prevent the airline from selectively returning some aircraft while keeping others. Cross- collateralization achieves the greatest benefits for aircraft financiers when a mixed
- 19 - NEWYORK/#96080.3 aircraft type is part of the EETC. When an EETC is issued, it is impossible to predict the aircraft type (e.g., narrow-body vs. wide-body) that the airline issuer will favor if and when it goes into bankruptcy. Having a mix that are cross-collateralized will then require the airline to retain all of the aircraft in a particular EETC pool if it seeks to retain any .25
·As a variation to cross-collateralization, in mortgage-financed transactions, require the airline issuer to purchase the most junior tranches. This will create incentives in a bankruptcy for the airline to not reject aircraft because, as a consequence of the cross-subordination, the cash flow generated by the non-rejected aircraft will inure the benefit of the senior certificate holders.
5. Trustee Issues.
The pass through trustees in EETCs have been unwilling to share investor lists with various interested parties in an EETC during restructuring and bankruptcy phases. Not having access to these lists has hampered the ability of investors, whether that is among the controlling party class or subordinated investors or lessors trying to contact each other or members of the controlling party, to be proactive. When an airline like USAirways rejects all of its Boeing contracts, with a view to keeping a limited number after restructuring the contract terms, EETC investors may be handicapped when, competing with private investors, they are unable to get together on a timely basis to make a proposal.
Possible Solution:
·Require trustees to furnish investor lists to interested parties in restructuring/bankruptcy scenarios.
6. Recovery Issues.
The costs of maintaining, storing, insuring and, if necessary, refurbishing aircraft are inevitable if the aircraft are returned by an airline following rejection of the underlying financing contract. Such costs are not inconsequential. They can run in the hundreds of thousands or millions of Dollars for a single aircraft, let alone an EETC “fleet”. The indenture trustee who acts on behalf of the holders of the equipment notes in respect of such matters may be reluctant to expend its own resources to effect such return costs and will be looking to the controlling party for the funds necessary to make these expenditures. This results in the following potential problem:
· If the controlling party consists of a number of parties, can these parties get organized to come up with the funds in a timely manner and will enough of them be prepared to make the very substantial expenditures which may be necessary to refurbish the aircraft before they can be leased or sold?
Possible Solution:
·Permit a liquidity facility to be used to fund these costs upon repossession.
25 It will likely be impossible to have equity investors in aircraft leveraged leases agree to cross-collateralization; accordingly, this will work only for mortgaged aircraft.
- 20 - NEWYORK/#96080.3 VI. Conclusion
As this article is going to press, the U.S. airline industry is going through wrenching dislocations, with a rather uncertain future facing those of us in the business of financing aircraft. Looking to the future, one hopes that the industry will recover and, in time, have requirements for new aircraft to be financed. Given the lack of depth in the bank markets, it will be incumbent upon the U.S. capital markets to satisfy financing requirements. In all likelihood, the EETC will be the capital markets product that will be looked to so as to satisfy such requirements.
In order for EETCs to succeed in the future, the subordinated classes of investors will likely require a number of structural changes. These structural changes, which may include some of the possible solutions outlined above, will for the most part come at the expense of the holders of the more senior debt tranches. These changes, however, may not be revolutionary from the perspective of the senior holders. The general paradigm of the EETC: on a default, the orderly liquidation of the aircraft collateral over a period of up to 18 months will return to the investor its investment, will continue to be the touchstone of the EETC. The changes we have outlined above really only serve to bring the structure back within this paradigm. In any event, the market and the ledger over intercreditor rights will need to evolve to woo back those subordinated investors on whose back the EETC structure rests.
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