Australia: "Hell and high water" provisions - has the storm abated? Leasing & asset finance in the transport industry

Introduction

On Monday 30 April 2012, the English High Court delivered its judgment in the case of ACG Acquisition XXLLC v Olympic Airlines (in special liquidation) [2012] EHWC 1070 (Comm.).

The case has attracted a high level of interest from the wider asset finance community, in particular as to when and in what circumstances rental provisions in a structured lease financing may be subject to challenge. In this article we pick out the main points of interest for those in the shipping industry.

Background facts

In 2008, ACG Aquisition XX LLC (the Lessor) had entered into an operating lease with Olympic Airlines SA (the Lessee) for the lease of a Boeing 737-300 aircraft for a term of five years, following redelivery of the aircraft from AirAsia.

The Lessor had given an undertaking in the lease that the aircraft would be airworthy and comply with detailed delivery condition requirements specified in the lease schedule. The aircraft was delivered on 19th August 2008, the Lessee having signed a certificate of acceptance in accordance with the delivery terms of the lease.

The Hellenic Civil Aviation Authority issued the aircraft with a certificate of airworthiness and the aircraft went into service on 23rd August 2008. On 6th September, the aircraft was grounded following the discovery of broken cables which controlled the spoilers in one wing. During repair, the Lessee discovered a number of defects leading to the suspension of the aircraft's certificate of airworthiness on 11th September. By July of the following year following year, despite extensive repair work, the CAA was still unable to reissue the certificate of airworthiness.

The Lessee claimed that the cost of repairs to make the aircraft airworthy would exceed the value of the aircraft and refused to pay rent. In September 2009, the Lessor issued proceedings against the Lessee for payment of outstanding rent and maintenance reserves under the lease and for damages. The Lessee issued a counter claim against the Lessor for damages for breach, in particular in relation to the delivery provisions of the lease.

The application for summary judgment took place in May 2010. Our aviation team issued a short briefing which can be found here. At the time, the judge refused to grant the Lessor summary judgment for the outstanding rent on the basis that the Lessee had established an "arguable" case both for breach of contract by the Lessor as to the delivery condition of the aircraft and as to whether there was a complete failure of consideration due to the poor state of the aircraft delivered. The case proceeded to full trial.

Full trial

At full trial, the Lessor claimed that it was entitled to rental and maintenance reserves under the lease terms which included a "hell and high water" type clause to pay rental in all circumstances. The Lessor argued that the aircraft was delivered in an airworthy condition in accordance with the delivery provisions of the lease, but in the alternative, the Lessor argued that even if the aircraft was judged to be unairworthy, the Lessee was estopped from alleging that the aircraft did not comply with delivery conditions and claiming damages as the Lessee had signed the certificate of acceptance which stated inter alia that the Lessee was "satisfied" with the aircraft and that the aircraft "complied in all respects with condition requirements at delivery" under the relevant provisions of the lease.

The Lessee contested the claim and counterclaimed for damages on the grounds that the aircraft had been delivered in an unairworthy condition in breach of the lease delivery conditions. The Lessee also sought to argue two further alternative arguments, one that by delivering an unairworthy asset, there had been a total failure of consideration and two, that the withdrawal of the aircraft's certificate of airworthiness had frustrated the lease.

Decision

The Court found in favour of the Lessor at full trial. It was accepted that the aircraft was not delivered in an airworthy condition. However, the Lessee had clearly accepted delivery of the aircraft under the certificate of acceptance, had signed the certificate before redelivery of the aircraft, and the Lessor's affiliate had relied on the signed certificate to its detriment, by accepting redelivery of the aircraft back from AirAsia in that condition. A link to a full briefing by our aviation team on the judgment can be found here.

The following points will be of particular interest to those in the shipping finance industry.

Drafting of delivery conditions

The case illustrates the importance of clear drafting as to the obligations of a lessor and the lessee on delivery of the ship. A well drafted lease should oblige a lessee to accept the asset in the "as is, where is" condition at delivery, without further recourse to the lessor after the date of delivery.

In Olympic, the Lessor undertook to deliver the aircraft in the condition set out in detail in Schedule 2 of the lease. This undertaking potentially cut across the "as is, where is" basis on which the aircraft was intended to be delivered to the Lessee.

Inspection of asset by the Lessee

In practice a lessee may have a limited time to inspect and take delivery of an asset. Nonetheless, the case underlines the importance of a lessee carrying out satisfactory checks as to any defects identified in pre-delivery inspections and/or agreement on any outstanding defects with the lessor before accepting delivery of the asset.

In Olympic, the Lessee had had the opportunity to inspect the aircraft prior to redelivery of the aircraft from AirAsia to the Lessor. A long list of discrepancies was agreed at the inspection. Although the subsequent maintenance carried out by AirAsia's MRO was the subject of some debate at trial, the fact that the Lessee was aware that the certificate of acceptance was to be signed and relied upon by the Lessor's affiliate before accepting redelivery of the aircraft from AirAsia prevented the Lessee from claiming damages on the facts.

"Hell and high water" provisions

Hell and high water provisions are intended to ensure that rental is payable in all circumstances and are a common feature of lease financing in shipping where dependence on a rental income stream is key to the financing structure.

Olympic was of interest to the asset finance community as it called into question whether such commercially agreed terms might be challenged where the condition of the asset delivered was so poor as to be beyond economic repair, making it impossible for the lessee to perform the contract. In Olympic, the Lessee had tried to argue that there had been a total failure of consideration in failing to provide an airworthy asset but this argument was rejected by Teare J. It was determined that the obligation to pay rental and maintenance reserves remained intact because the Lessee has "irrevocably and unconditionally" accepted and leased the aircraft from the Lessor pursuant to the wording contained in the certificate of acceptance.

Whilst the case gives some comfort to lessors as to rental obligations of this nature being upheld, Olympic has nonetheless tested assumptions as to when such provisions might be challenged. In shipping a challenge is more likely to occur in the context of a time or voyage charter, where a shipowner will have ongoing obligations as to the maintenance and operation of the ship.

The "classic" common law test : is a ship seaworthy?

The Olympic case was of interest to aviation financiers as the Court considered the meaning of "airworthiness" for the first time. In considering the meaning of "airworthy" the Court did not accept that the existence of a certificate of airworthiness was sufficient but relied on the classic test of seaworthiness being: "Would a prudent owner have required that the defect should be made good before sending his ship to sea, had he known of it. If he would the ship was not seaworthy?"¹

The test is a reminder of the common law test when using the definition of "seaworthiness" in finance documentation. In a ship lease financing, a shipowner will typically confirm to the lessor that the ship is in a "seaworthy" condition on delivery of the ship. In turn, a shipowner will have an obligation to deliver the ship to a third party charterer in a seaworthy condition. In the next edition of Legalseas we will look at the meaning of "seaworthiness" in more detail and what this means in practice.

Conclusion

Overall the judgment in Olympic should not cause undue concern for the shipping finance community given that the facts of the case were quite unusual and specific to the parties involved. However there are some cautionary lessons that can be drawn from the judgment as illustrated above. As to the challenge to "hell and high water" rental obligations, the storm may have eased for the moment now but perhaps has not fully abated.

Footnote

¹ Scrutton LJ, FC Bradley & Sons v Federal Steam Navigation Co (1926) 24 LI. Rep 446

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.