Airlines and aircraft lessors would be well advised in today's economic climate to remain attuned to litigation outcomes that may affect the traditional rules for aircraft financing. Courts have recently decided cases involving applicability of insurance clauses in lease agreements, interpretation of lease terms controlling parties' obligations, lessors' rights upon default, lease obligations following bankruptcy, and the enforceability of liquidated damages provisions in lease contracts.1
Insurance Clauses in Lease Agreements
When a lessee breaches a lease, interpretation of an insurance clause may prove key to the lessor's attempts to mitigate damages. In Fleet Business Credit L.L.C. v. Global Aerospace Underwriting Managers, Ltd., 646 F. Supp. 2d 473, 475 (S.D.N.Y. 2009), the lessee, after filing for bankruptcy, intentionally removed component parts from the aircraft financed by the plaintiff lessors. Subsequently, the lessors submitted claims for the missing parts to the lessee's insurance broker. Although a plain reading of the lessee's insurance policy provided that intentional acts were not covered under the policy, the plaintiff lessors argued that although the lessee intentionally removed the parts, the removal was "accidental" in relation to the plaintiffs. The lessors also cited to the "Airline Finance/Lease Contract Endorsement" clause (also known as the AVN 67B or 67C Endorsement), providing that the coverage for each contract party under the policy would not be invalidated by any act or omission of any other person or party that results in a breach of the policy.
The district court rejected the lessors' argument, explaining that the scope of the policy's coverage was unambiguous and did not cover intentional acts. Thus, the interpretation and applicability of the "Airline Finance/Lease Contract Endorsement" clause was a secondary issue that would be relevant only to the lessors' attempt to recover their losses from the lessee's insurance policy if the policy's terms were ambiguous with respect to coverage of intentional damage. Accordingly, the court granted the insurance company's motion for summary judgment with respect to the component parts that were intentionally removed by the lessee's employees.
Interpretation of Lease Terms Controlling Parties' Obligations
Consistently and unambiguously defining contract terms in an
aircraft lease such that there is little room for more than one
legitimate interpretation remains an important issue. In Wells
Fargo Bank Northwest, N.A. v. US Airways, Inc., No. 650500/09,
2011 WL 1107127, at *1, (N.Y. Sup. Ct. Mar. 21, 2011), the parties
disagreed over the term "delivery" where the defendant
was obligated to return the leased aircraft weighing the same
"as at delivery." According to the plaintiff, the term
referred to the weight of the aircraft at the beginning of the
lease. However, the defendant claimed the definition of the term
varied in the contract depending upon whether the term was
capitalized, alleging that when the term was capitalized, it
referred to delivery of the aircraft at the beginning of lease, but
when the term was not capitalized, it referred to delivery from the
manufacturer. After analyzing the lease agreements, the court noted
that the agreements never referenced delivery from the
manufacturer. Thus, the court concluded that "delivery"
referred only to the beginning of the lease and granted plaintiff
summary judgment on liability.
Similarly, in Addison Express, L.L.C. v. Medway Air Ambulance,
Inc., No. Civ. 3:04-CV-1954-H, 2006 WL 1489385, at *1 (N.D.
Tex. May 19, 2006), Addison Express ("ADEX"), the lessee,
attempted to argue that a 24-month lease term required Medway, the
lessor, to make "twenty-four separate consecutive
deliveries" of the aircraft.2 Medway delivered the
aircraft to ADEX in October 2003, and ADEX took possession of the
aircraft at that time. The following summer, the United States Drug
Enforcement Agency ("DEA") instructed Medway to cease all
activity with regard to the aircraft. Though ADEX subsequently
obtained a conditional release from the government, Medway notified
ADEX that it was terminating the lease as a result of the seizure.
ADEX filed suit, claiming that Medway had breached the lease
contract by failing to make the required payments after the
aircraft was seized. Medway argued that "delivery" failed
after the aircraft was seized by the DEA. However, the court
rejected Medway's argument, explaining that the lease required
"a single delivery of a single good," and that ADEX
fulfilled its delivery obligation when it delivered the aircraft to
Medway in October 2003.
While consistently and unambiguously defining contract terms in an
aircraft lease is important, Addison Express v. Medway Air
Ambulance also illustrates that litigation may often be
inevitable despite unambiguous lease terms. In addition to
asserting that the lease required 24 separate deliveries, Medway
also attempted to convince the court that its failure to insure the
aircraft against government seizure did not constitute a breach of
the lease contract and ultimately an act of default. Medway's
president asserted that he interpreted a specific clause in the
lease to make seizure insurance optional. The language at issue
provided that in the event that the aircraft was seized and
"there exists no valid and collectible insurance under any
insurance policy," Medway would pay ADEX a lump sum in
addition to any other damages or remedies available at law or in
equity.3 The court concluded that the language, rather
than relieving Medway of its obligation to obtain insurance,
"expressly reserves ADEX's right to pursue legal remedies
for breach, without excluding default for failure to buy
insurance."4
Lessors' Rights Upon Default
In Canal Air, L.L.C. v. William B. McCardell, No.
11-11081, 2011 U.S. Dist. LEXIS 123572 (E.D. Mich. Oct. 26, 2011),
defendants voluntarily relinquished their possession of the leased
aircraft after defaulting on their payment obligations. Canal Air
subsequently sold the aircraft and filed a lawsuit against
defendants in order to recover the deficiency and attorneys'
fees. Canal Air moved for summary judgment, but defendants alleged
that summary judgment was not appropriate because Canal Air failed
to establish that disposal of the aircraft was "commercially
reasonable" or that it provided defendants reasonable notice
prior to the sale. The lease agreement provided that Canal Air
could sell the aircraft with or without notice in the event of
default. However, despite this unambiguous language, the court
denied Canal Air's motion for summary judgment. The court
explained that New York law provides that a debtor's rights to
a commercially reasonable sale and notice prior to the sale cannot
be waived prior to default. Thus, the language in the lease did not
constitute a valid waiver of the defendants' statutory
rights.
Two recent cases have illustrated that lawsuits seeking to pierce
the corporate veil in an effort to find all liable parties after a
lessee defaults may be unsuccessful unless the lessor asserts a
claim of fraud. The cases also suggest that establishing the
existence of fraudulent conduct, a fact-intensive issue, may be
difficult. In NetJets Aviation, Inc. v. Peter Sleiman
Development Group, L.L.C., No. 3:10-cv-483-J-32MCR, 2011 U.S.
Dist. LEXIS 114081, at *1 (M.D. Fla. June 13, 2011), plaintiffs
operated a fractional ownership program that allowed multiple
individuals or entities to co-lease aircraft. A corporation,
J.Ward, purchased and leased fractional interests in two airplanes
but failed to make the required payments. After receiving a
judgment against J.Ward, plaintiffs discovered, among other things,
that Jennifer Ward was the sole shareholder of J.Ward; that one of
the defendants lived with Jennifer Ward; that one of the defendants
gave money to J.Ward without loan arrangements or agreements; and
that the defendants used J.Ward to execute contracts with
plaintiffs in order to access and use aircraft without being liable
for the services. Thus, plaintiffs alleged that Jennifer Ward ran
J.Ward for the benefit of the defendants and sought to pierce the
corporate veil.
Defendants filed a motion to dismiss, alleging that plaintiffs had
failed to establish that either defendant was an alter ego of
J.Ward or that the corporate form was used fraudulently or for an
improper purpose. The magistrate judge concluded that the
defendants could be considered the alter ego of J.Ward even though
they were not shareholders of J.Ward, but he concluded that the
allegations regarding the defendants' interactions with J.Ward
were insufficient to constitute fraudulent or improper conduct.
Thus, the magistrate judge recommended that defendants' motion
to dismiss be granted. However, after reviewing the facts, the
district court judge concluded that it was premature to foreclose
the possibility that plaintiffs could establish that
defendants' conduct constituted fraud and thus denied
defendants' motion to dismiss.5
Similarly, in Charter Services, Inc. v. DL Air, L.L.C.,
711 F. Supp. 2d 1298, 1300 (S.D. Ala. 2010), three defendants, one
of whom owned 100 percent interest in the lessee's company as
well as significant shares of the other two defendant corporations,
made most of the payments for the leased aircraft. Thus, the
plaintiffs argued that the defendants should be liable for the
lessee's breach of contract. In determining whether to pierce
the corporate veil, the court analyzed the corporation's
operations, but explained that the ultimate issue was whether the
"plaintiffs presented substantial evidence of the existence of
fraud or inequity in the use of the corporate
form."6 The court also noted that the "fraud
or injustice must be more than the breach of
contract."7 Thus, the court refused to pierce the
corporate veil and granted the defendants' motion for summary
judgment because the plaintiffs' only evidence of fraudulent
conduct related to the defendants' breach of contract.
Lease Obligations Following Bankruptcy
Airline bankruptcies continue to complicate the expectations of
aircraft financiers. In Bremer Bank, National Ass'n v. John
Hancock Life Insurance Co., No. Civ. 06-1534, 2009 WL 702009,
at *1 (D. Minn. Mar. 13, 2009), aff'd, 601 F.3d 824 (8th Cir.
2010), the court upheld the foreclosure of the owner
participant's equity share in a bankrupt airline as a result of
a bankruptcy proceeding. The defendants gave instructions to the
trustee to foreclose plaintiff's equity share, and the
plaintiff claimed that the lease agreement required defendants to
exercise remedies against the bankrupt airline prior to exercising
remedies against the plaintiff. However, the defendants asserted
that they had in fact exercised remedies against the airline prior
to foreclosure of plaintiff's equity share. Accordingly, the
case turned in part on whether the parties intended that there be a
difference between language providing for "steps leading up to
the exercise of a remedy" and the "exercise of a
remedy." The court, relying on Lone Star Air Partners,
L.L.C. v. Delta Air Lines, Inc., 387 B.R. 426 (S.D.N.Y.
2008),8 declined to recognize a distinction between
"steps leading up to the exercise of a remedy" and the
"exercise of a remedy." Thus, the court held that the
defendants followed the appropriate procedures prior to foreclosing
on the plaintiff's equity interest.
In an earlier case, In re Northwest Airlines Corp., 383
B.R. 575 (Bankr. S.D.N.Y. 2008), the court concluded that the
lenders had not foreclosed on their security interest in the
aircraft lease or its proceeds when they foreclosed on their
security interest in the aircraft. Prior to bankruptcy, Northwest
had entered into a leveraged lease of an aircraft. Penta Aviation
was the beneficiary of an "owner trust" created to hold
title to the aircraft and to lease the aircraft to Northwest. The
lenders provided Northwest with most of the purchase price for the
aircraft in exchange for a first priority security interest in the
aircraft and the lease.
After Northwest rejected the lease and abandoned the aircraft, the
lenders sent the trustee of the owner trust, Penta, and Northwest
an Acceleration Notice defining collateral as the aircraft and the
aircraft lease. However, when the Notice of Public Foreclosure Sale
was published, it did not reference the lease or a claim for
damages for breach of the lease. The court rejected the
lenders' argument that the lease was conveyed as a matter of
law with the aircraft, explaining that, at the time of foreclosure,
the lease did not encumber the aircraft because Northwest had
previously rejected the lease. The lease merely represented "a
claim for damages against the lessee."9
Accordingly, the court held that the lenders had not "obtained
all right, title, and interest of the Owner to a damages claim
against [the airline],"10 and that the owner was
the proper party to assert a damages claim for the airline's
breach of the aircraft lease.11
Enforceability of Liquidated Damages Provisions
In yet another bankruptcy case involving Northwest Airlines, In re Northwest Airlines Corp., 393 B.R. 352 (Bankr. S.D.N.Y. 2008), the court, applying Minnesota law rather than the Uniform Commercial Code,12 concluded that the liquidated damages clauses in two aircraft leases were unreasonable and thus unenforceable. The court explained that the liquidated damages clauses were unreasonable because the calculation of damages was based on a static stipulated loss value ("SLV") that did not allow for depreciation of the aircraft over time and did not account for the lessee's payment of rent over the course of the lease. Moreover, the court indicated that SLV, a liquidated damages provision common in aircraft leases, would have been an appropriate template for the calculation of liquidated damages if the SLV declined over the course of the lease term. Other courts have also enforced liquidated damages provisions that account for depreciation and rental payments.13 Finally, addressing the lessor's argument that the court should consider the parties' sophistication when judging the reasonableness of the liquidated damages clause, the court noted that it is inappropriate to bind sophisticated parties to "patently unreasonable" liquidated damages provisions.
"Hell or Highwater" Clauses
As we have reported previously,14 a key factor in
ensuring that any lease is financeable is whether the lease
contains a "hell or high water" clause, requiring that
rental payments will be made regardless of the condition of the
aircraft. Historically, courts have uniformly recognized this type
of provision and have consistently upheld its enforceability. Two
recent court decisions, however, have been divided on that
presumption.
In ACG Acquisition XX L.L.C. v. Olympic Airlines, S.A.
[2010] EWHC 923 (Comm), a U.K. court refused to grant summary
judgment to the lessor, ACG Acquisition XX L.L.C.
("ACG"), in a claim for unpaid rent by the lessee Olympic
Airlines, S.A. ("Olympic"). Olympic stopped paying rent
on a leased aircraft when it determined that, after the aircraft
lost its Certificate of Airworthiness, repairs exceeded the value
of the aircraft. Notwithstanding a fairly standard "as
is-where is" disclaimer and a "hell or high water"
clause in the applicable lease, the court refused ACG's summary
judgment application and held that an aircraft suitable for
immediate operation in commercial service had never been
supplied.
In comparison, in Jet Acceptance Corp. v. Quest Mexicana, S.A.
de C.V., No. 602789/08, 2010 WL 2651641, at *1 (N.Y. Sup. Ct.
June 23, 2010), the New York court produced a more
financier-friendly result. Jet Acceptance Corp. ("JAC")
and Quest Mexicana, S.A. de C.V. ("Quest") entered into
four aircraft operating lease agreements. Each lease agreement
included a "hell or high water" clause requiring Quest to
pay rent and perform all of its other obligations under the lease
notwithstanding any defense or other circumstance.
After accepting the first aircraft for delivery and acknowledging
in an Acceptance Certificate that the aircraft was delivered to
Quest "as is-where is," Quest failed to remove the
aircraft from its location and made only two payments on the
aircraft. Subsequently, JAC tendered the remaining three aircraft
pursuant to the terms of the lease, but Quest failed to comply with
the delivery procedures or to make the required rental payments
after it was deemed to have accepted delivery of the aircraft.
While Quest sought to avoid the "hell or high water"
clauses, the court recognized that "hell or high water"
provisions are commonly respected and enforced in equipment leases.
Moreover, the court precluded the airline from raising the doctrine
of unconscionability to preclude enforcement of the clauses.
On appeal, the appellate court affirmed the lower court's
decision in 201115 but noted that JAC ultimately did not
need to rely on the "hell or high water" provisions. The
court explained that while the "hell or high water"
provisions required Quest to perform its obligations under the
leases even if there was a legitimate reason not to perform, Quest
had failed to establish that it had a legitimate reason for
refusing to perform its obligations. Furthermore, the appellate
court agreed that the doctrine of unconscionability rarely applies
in a commercial setting.
Conclusion
Skilled counsel will want to study these recent court decisions and implement "lessons learned" when drafting new leases and advising clients regarding future disputes. Airlines and financiers must make every effort to define contract terms in aircraft leases consistently and unambiguously. Moreover, lessors must also remember that they cannot draft around debtors' statutory rights. Finally, recent cases also illustrate the importance of considering how a lessee's bankruptcy will affect the lease. Awareness of the recent trends in aircraft finance litigation will enable airlines and financiers to better protect their interests when drafting lease agreements and better defend against lawsuits involving the enforceability of lease provisions.
Footnotes
1. Our article focuses on cases addressing issues specific to aviation finance rather than cases addressing general principles of contract law.
2. Addison Express, 2006 WL 1489385, at *3. ADEX
essentially argued that the lease should be construed as an
installment contract.
3. Id. at *9.
4. Id. at *10.
5. NetJets Aviation, Inc. v. Peter Sleiman Development Group,
L.L.C., No. 3:10-cv-483-J-32MCR, 2011 U.S. Dist. LEXIS 109973,
at *1 (M.D. Fla. Sept. 27, 2011).
6. Charter Services, 711 F. Supp. 2d at 1309.
7. Id.
8. The Second Circuit Court of Appeals ultimately vacated the
district court's opinion in Lone Star Air Partners, L.L.C.
v. Delta Air Lines, Inc., noting that while both the
bankruptcy court and the district court concluded that the relevant
contract language was unambiguous, both courts disagreed about the
meaning of the language. Thus, the court remanded the case to the
bankruptcy court for an evidentiary hearing to determine the
meaning of the contractual language at issue. In re Delta Air
Lines, Inc., No. 08-2825-bk, 2009 WL 577588, at *3-4 (2d Cir.
Mar. 5, 2009).
9. In re Northwest Airlines Corp., 383 B.R. at
583.
10. Id. at 582.
11. The court noted that the lenders' security interest in the
aircraft lease was not eliminated when they foreclosed on the
aircraft, and that the lenders "may have a lien on the
proceeds of the Owner's Claim." Id. at
584.
12. Article 2A of the U.C.C. applies to any transaction that
creates a lease, but the leases at issue in this case provided that
Minnesota law governed all matters of construction, validity, and
performance.
13. See Wells Fargo Bank Northwest, N.A. v. Taca Int'l
Airlines, S.A., 315 F. Supp. 2d 347, 349-50 (S.D.N.Y.
2003).
14. See E. Evans and D. Reddy, "The 'Hell or
Highwater Clause': A Closer Look at its Legal Enforceability by
Courts in the United Kingdom and New York," Jones Day
Airlines and Aviation Alert (Fall 2010). We repeat the
discussion of these cases for completeness and because of their
relevance to the area of aviation finance.
15. Jet Acceptance Corp. v. Quest Mexicana, S.A. de C.V.,
No. 5089, 602789/08, 2011 N.Y. App. Div. LEXIS 6272, at *1 (N.Y.
App. Div. Sept. 1, 2011).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.