Alert: Debt Restructuring and Liability Management – Managing times of Distress for Airlines February 2019 In October 2018, we wrote an article on airline restructuring and insolvency, where we considered the key operational risks which have implications for airline survival. That article was written in light of the failure of Primera Air. Contributing Authors: Since that article was written, the wave of distress within the aviation industry has continued, and there have been further casualties. Cobalt Air, a Cypriot carrier, collapsed in October after the Chinese state-owned Aviation Industry Corp, Cobalt’s 49% shareholder, declined to provide additional funding. The Chinese investment in Cobalt was part of the "One Belt, One Road" project under which China aims to link itself to Europe via Central Asia. Air Zimbabwe, unprofitable for decades, filed for administration late last year. Additionally, several other private airlines, including Small Planet Airlines, Skywork, and, more recently, Germania and Flybmi, have also collapsed. A number of state-owned airlines around the world have also ratcheted up their dependency on their respective governments to stay afloat. Sri Lankan Airlines was reported to be cash strapped even after capital injections from the Sri Lankan Government, whilst South African Henry Kikoyo Airways continues to rely on support from the South African Government, which [email protected] recently invested a further five billion rand. +44.207.851.6084 Failure in the airline business is not new, and has been a more common occurrence since the Carter administration kick-started the deregulation of the Henry Kikoyo is a Partner at Brown airline business in the late 1970s. Renowned investor Warren Buffet reportedly Rudnick LLP and regularly advises described the airline industry as “being labour intensive, capital-intensive with in relation to airlines in distress and high fixed costs that has been the death trap of investors”. The recent failures all insolvency including debt and share a common pattern of business misfortunes. These include an increased operational restructuring. He has cost structure, mainly driven by the rise in fuel and carbon prices, over capacity, particular experience acting for increased competition from low-cost carriers, and a lack of new money or equity airlines operating in emerging injection. markets which are faced with inadequate institutional and legal Yet, despite the many horror stories, there continues to be a wave of airline start- framework to support effective ups. In Africa, several governments are setting up new airlines many years after turnaround initiatives. He also acts the collapse of their previous legacy airlines. Senegal and Tanzania set up new for lessors and creditors in relation airlines in 2017 and 2018. Uganda and Zambia are reportedly in the process of to recovery out of insolvent airlines setting up new airlines, as well. Rwandair continues to expand with the support of including enforcement and its government, as does Kenya Airways, which is still in the midst of a turnaround. repossession of aircraft. He is part These governments view aviation policy as being central to their economic of a Transatlantic team of lawyers development and modernisation. The airline business is here to stay, which practicing in aviation, insolvency means that getting to grips with how to deal with distress and the cyclical nature and other sectors, who are well of the business is critical to long-term survival and prosperity. prepared to advise on complex This article supplements our article of October 2018 on turnaround strategies in and cross-border legal problems relation to debt restructuring and liability management. The high cost structure arising out of specialist sector of the airline business inevitably leads to accumulation of significant debt and insolvencies. liabilities, which are generally of a cross-border nature. Therefore, the ability to 1. Law 360 - "Critical Factors for Airline Survival and Restructuring". © 2019 Brown Rudnick LLP - Attorney Advertising | 1 manage debt and liabilities on an international scale is critical. The strategies employed may be on a consensual basis with key stakeholders, which is often the preferred option, or within an insolvency legislative framework, as a tool of last resort (if available). Some strategies are "offensive", and thus geared towards revenue generation, whilst others are "defensive" and geared towards revenue protection. However, it is important to bear in mind the following points: i. there is quite a bit of room for creativity in employing these strategies and - just as no two airlines are the same - no two turnaround plans will be the same, ii. a critical success factor in any debt restructuring and liability management exercise is the simultaneous application of multiple strategies(i.e. the multi-faceted approach), and iii. the strategies must be deployed having taken into account applicable laws, including insolvency laws, notwithstanding the fact that the airline may not yet be formally insolvent (for example, the airline needs to be cognisant of "preferring" certain creditors, or putting assets beyond the reach of creditors). A high-level overview on some key debt restructuring and liability management strategies follows. A. Debt reduction through compromise: In order to fund the high labour and fixed costs, many airlines inevitably have to borrow money. Aircraft (along with their components, such as engines) represent the highest fixed costs whilst fuel and labour tend to represent the highest variable costs. Aircraft acquisition is usually financed through financing leases or operating leases. In the case of finance leases the airline borrows part of the financing and/or equity finances any balance required to pay for the cost of the aircraft. The airline pays interest on the financing and repays the principal upon maturity of the loan and, by doing so, it acquires ownership of the aircraft subject to a mortgage in favour of the lenders. The aircraft will appear on the balance sheet of the airline as an asset and the corresponding liability will appear as debt. For operating leases the airline leases the aircraft for a prescribed period of time in return for payment of a security deposit, rent, and maintenance reserves. The airline does not acquire ownership of the aircraft, only a “right of quiet enjoyment”. Under current international accounting rules the aircraft does not appear as an asset on the balance sheet of the airline. Fuel is generally expensive, and its pricing is erratic with significant upward and downward swings. Therefore, there are various fuel procurement structures under short-term and long-term arrangements. Additionally, labour costs can be high and are often also wedged within the politics of labour unions. For example, the costs of crew (in particular, cockpit) may not be in line with the local labour market since these are often benchmarked internationally. A distressed airline facing a high debt burden may have its work cut out for it. As already highlighted, this can be further complicated by the cross-border or international nature of creditors. However, distressed airlines should not shy away from engaging with creditors to achieve a compromise. In our experience, if properly advised and with the right approach, a distressed airline can often secure a compromise with at least the majority of its creditors. Creditors faced with a distressed borrower or counterparty will often have a range of options available to them, and will weigh the likely outcomes from the options and pursue what they believe best optimises their recovery. Creditors, particularly those which are unsecured, will be wary that their actual recovery in a liquidation scenario will likely be significantly diminished. Creditors also have other considerations, such as reputational risk and long-term relationships, which the airline or its advisors have to tap into when formulating compromise proposals. This is an art, and engaging the right advisors is key. If the creditors are poorly managed, this can lead to the quick or premature demise of the airline. We set out below some of the possible negotiating points and strategies airlines can adopt toward their various creditors. Creditor classes: For the purposes of facilitating negotiations with creditors, the airline may group them into appropriate "classes" in line with the similarity of their rights or claims, and in turn prepare compromise proposals for each class. This promotes some form of fairness in treatment. As a broad example, the following classes may exist for an airline business: • priority creditors (e.g. employees, tax authorities, airport traffic and ground handing); • secured creditors (e.g. aircraft financiers, lessors); • trade creditors (who are vital for the operations of the business e.g. catering, fuel); and • unsecured creditors. Standstill: In a consensual resolution, the creditors can be persuaded to refrain from taking any adverse action for a period of time in order to give the airline some breathing space to find a solution. In practice this can be. © 2019 Brown Rudnick LLP - Attorney Advertising | 2 complicated, especially when dealing with creditors who have sufficient leverage to disrupt the operations of the airlines such as the aircraft lessors or fuel suppliers. It all comes down to negotiation skills including finding win-win situations that are workable for the relevant stakeholders Renegotiation of financing terms: This includes renegotiation of the terms of the financing agreements such as reduced interest rates, reduced lease or maintenance reserve rates, extension of maturity dates, reset of covenants, waiver or suspension of events of default/other breaches, clean-up periods to allow defaults to be cured, to name a few. The objective of the airline is to realign its obligations with its cash flow. The lender/lessor may agree to the renegotiated terms in return for a strategic benefit. This may be to avoid the inconvenience, obstacles and value destruction associated with enforcement, or for a consent fee, or to support the continuing survival of the airline for future business.