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.