Aircraft lease securitizations April 13, 2020 2020 | By: Patrick Dolan, Alexandra Howe, Deborah Stern, and Chana Ben-Zacharia, Norton Rose Fulbright US LLP This practice note explains the structure of aircraft lease securitizations and certain bankruptcy and rating agency issues that must be considered in structuring these transactions, the benefits of using the debt capital markets for aviation financing, and the issues for the aircraft lease securitization market during 2020. COVID-19 Concerns Introduction The recent coronavirus outbreak that began in Wuhan, China in Aircraft lease securitizations generally come in two types: aircraft December 2019 that causes a respiratory illness called COVID-19 lease portfolio securitizations and enhanced equipment trust has now been reported on every continent except Antarctica. certificate (EETC) securitizations. The aviation sector is directly being impacted by all of the virus containment measures. As a result of governmental travel • Asset-backed aircraft lease securitizations. In the typical restrictions and social isolation tactics, the airlines have been aircraft lease portfolio securitization, the issuing special compelled to reduce flights, ground aircraft, and temporarily cease purpose subsidiary of the sponsor, which is a newly formed operations. It is not unanticipated that many will face bankruptcy. bankruptcy-remote entity, owns the equity in various special Based on a recent ABS surveillance report, KBRA expects that purpose entities (SPEs) that each owns an aircraft or aircraft from a credit standpoint global aircraft lease securitizations will engine that is leased to an airline. Normally, the lessees or suffer a hard hit. With the lack of air travel, it is no surprise that airlines are located in the United States and around the world. airlines are requesting rent and maintenance deferrals, which Thus, unlike an EETC aircraft lease securitization (discussed in some cases represent upwards of approximately 80% of below), the aircraft lease portfolio securitizations rely in part lease revenue in some transactions. The degree to which each on diversification of credit risk. Similarly, remarketing or transaction is impacted will vary depending on the amount of releasing of aircraft plays a bigger role in aircraft lease portfolio payment deferrals, delinquencies, airline bankruptcies, collateral securitizations so the quality of the servicer is more important. performance, strength of the servicer, and transaction structure. • Enhanced Equipment Trust Certificate aircraft Without an end in sight for this pandemic, the global economic lease securitizations. In the typical EETC aircraft lease impact of such a worldwide shutdown is unknown but more securitization, the issuing entity (issuer-lessor), which is a severe downgrades are likely to follow. newly-formed bankruptcy-remote SPE and a subsidiary of the sponsor airline, owns a portfolio of aircraft and leases the aircraft to the sponsor airline. As a result, the transaction looks more like a corporate bond offering by the sponsor airline, but the sponsor airline can obtain a better rating on the EETCs than it could on its corporate bonds because of the securitization features. 01 Aircraft lease securitizations Transaction Structure The diagram below shows the structure of a typical aircraft lease portfolio securitization: Third Party Purchaser Sale of equity/ Aircraft Leasing residual interest Trustee for Noteholders Company Noteholders Notes Pledge of equity interests in aircraft- owning entities Liquidity Facility Issuer Servicer Provider Sale of aircraft Seller Cash Manager 100% equity interest Aircraft-Owning Special Purpose Entities (Corporate entities or trusts) Entity 1 Entity 2 Entity x Lease Lease Lease Airline Airline Airline The diagram below shows the structure of a typical EETC aircraft lease securitization: Lease of Aircraft Pledge of Leases Liquidity Facility Airline Issuer Provider Lease Payment Note Note Note Note Payments Trustee for Payments Payments Payments Noteholders Class A Class B Class C Noteholders Noteholders Noteholders 02 Aircraft lease securitizations Key Features of the Transaction In an EETC aircraft lease securitization or an aircraft lease portfolio securitization involving the bankruptcy of a foreign airline, Section Structures 1110 of the U.S. Bankruptcy Code would not be available. Instead, the lessor would have to rely on the 2001 Cape Town Convention In both aircraft lease portfolio securitizations and EETC aircraft and its Aircraft Equipment Protocol (collectively, the Cape Town lease securitizations, there is a liquidity facility provided by a Convention) discussed below in Insolvency Issues. Finally, prior highly-rated bank to ensure the payment of interest during an to the 2008 credit crisis, monoline insurance companies often aircraft remarketing period (up to 18 months) following a default provided bond insurance for bonds issued in aircraft lease by an airline lessee. In EETC aircraft lease securitizations involving securitizations. Since the credit crisis, however, aircraft lease U.S. airlines, the lessor would typically rely on Section 1110 of the securitizations no longer have this feature but rather rely on, U.S. Bankruptcy Code to repossess an aircraft from a bankrupt among other things, over-collateralization. lessee. Section 1110 permits a lessor to repossess an aircraft if the bankrupt lessee does not elect to assume the lease and cure all The sponsor or an affiliate of the sponsor is normally the defaults within 60 days of the bankruptcy filing. servicer in an aircraft lease securitization. In an aircraft lease portfolio securitization, it is not unusual to have two issuers of In both types of securitizations, the lessor will typically grant the bonds, a Delaware issuer and a Cayman Island issuer, and possessory and security rights to a security or indenture trustee, local law mortgages are not taken over the aircraft. Aircraft lease which will represent and act on behalf of the noteholders. securitizations also often have many of the following features: Following a default, the trustee will have the ability to enforce legal and contractual remedies against such rights in accordance • A maintenance reserve account that is funded at closing and with the relevant law and the terms and conditions of the trust replenished during the course of the transaction indenture and the security trust agreement. The types of rights pledged to the trustee often include: • Performance triggers such as aircraft utilization rate, loan-to- value ratio and debt service coverage ratio (a default of either • Lessor rights under the lease, to receive rental payments could result in a cash sweep and/or a cash trap) directly and perform other acts reserved for the lessor, • A feature that permits the sponsor to sell a limited percentage including without limitation, if there is an event of default, then (e.g., 10%) of the portfolio at purchase prices below the the trustee shall be entitled to exercise all rights, remedies, allocable debt amount for such sold aircraft powers and privileges of Lessor, as lessor • Concentration limits on, among other things, aircraft model, • Ownership rights in the aircraft, to enforce a deregistration engine model and jurisdiction of lessees power of attorney to take possession of and remarket or re- lease the aircraft • A provision allowing for substitution of aircraft subject to certain conditions, for example • Rights to any proceeds from the lessee’s insurance policy relating to the aircraft, to collect such proceeds and distribute — No event of default or rapid amortization event has to the noteholders in an event of loss –and– occurred • Membership rights in the lessor itself, to take control of the — The substitution occurs prior to specified anniversary of the lessor and act in its stead closing date (e.g., the seventh anniversary) This trustee arrangement allows for trustee companies — The substitution will not result in a concentration limit being experienced in aircraft lease securitizations to centralize the exceeded decision-making process for several noteholders and to protect — The substitute aircraft has a value at least equal to the the rights and interests of those noteholders without requiring disposed aircraft and is of the same, or a newer, model them to develop industry expertise. –and– — The value of all additional aircraft does not exceed a specified percentage of the initial value of the portfolio at closing 03 Aircraft lease securitizations • A provision requiring each lease to meet certain criteria (e.g., In non-Cape Town Convention countries, investors must minimum term, lessees’ credit rating, etc.) determine what protections there are for creditors in an airline bankruptcy in the jurisdiction of the lessee. • A provision requiring the issuer to enter into an interest-rate protecting hedging agreement shortly after the funds are drawn Rating Agency Considerations • A provision allowing the issuer to use a portion of the lease security deposits for working capital subject to certain Some of the factors that a rating agency will consider in rating an conditions aircraft lease securitization include: While in theory it is possible to have an EETC aircraft lease • Lessee credit quality securitization involving a non-U.S. airline as the sponsor, these transactions are not common. • Country risk • Lessee concentration Another feature found in recent aircraft lease portfolio securitizations is the sale of the residual or equity interest