UK: Engine And Component Cannibalisation: A Step Too Far?

Last Updated: 7 January 2010
Article by Zohar Zik

Zohar Zik examines the court decision in U.S. Bank National Association v Southwest Airlines Company1, which addresses potential pitfalls associated with the practice of substituting engines and parts of leased aircraft. The implications of this decision give rise to a number of practical considerations, which are also discussed.

Key facts

In June 1987, Southwest Airlines Company ("Southwest") took three Boeing 737-3H4 aircraft (the "aircraft") on lease from U.S. Bank National Association (as successor owner trustee) ("BNA"). The aircraft were leased under three identical lease agreements (collectively referred to as the "lease"), which contained the following provisions:

1 Section 5(a) permitted replacement of engines provided that, at lease return, they were of equivalent utility and value and, when installed and used on the airframe, would not impair the value or utility of the aircraft. The section also provided that, at aircraft return, each replacement engine had to have at least 1,750 cycles remaining before the next scheduled engine overhaul.

2 Section 8, which dealt with the replacement of "parts," permitted replacement of parts in the ordinary course of maintenance, service and so on, as long as all replacement parts would be in as good operating condition as, and have a value of and utility at least equal to, the parts replaced.

3 Section 7(a) required Southwest to keep the aircraft maintained in the same manner and with the same care as similar aircraft that it owned.

When the lease expired in 2008, Southwest returned the aircraft, but BNA claimed that Southwest had failed to meet certain requirements under the lease in respect of their return. In particular, BNA objected to Southwest's replacement of engines, certain components and parts, with less valuable engines, components and parts just a few months prior to lease expiry.

At the hearing, BNA argued that the words "utility" and "value" as used in Section5(a), required the lessee to return engines with a "monetary worth and usefulness" at least equivalent to that of the original engines and parts. The fact that the engines returned had more than 1,750 cycles remaining in them at return was in itself immaterial because Southwest had failed to comply with its obligations regarding replacement of engines. BNA also argued that Southwest had discriminated against the leased aircraft in violation of Section 7(a).

Southwest contended that the terms "value and utility" had not been defined in the lease and, accordingly, the wording of Section 5(a) was ambiguous. Southwest sought to support this contention by an expert opinion which stated that the term "value", for example, could relate to 18 different types of value, including replacement cost, reproduction cost, fair market value, insurance replacement cost and liquidation value. On that basis, Southwest argued that it only had to comply with the requirement that the replacement engines had to have at least 1,750 cycles remaining before next overhaul, and that the words "value and utility" imposed no additional duty on Southwest. Southwest offered no substantive defence to the claims by BNA that it had breached its obligations under Sections 7(a) or 8.

The court found that the evidence against Southwest, both in respect of its conduct, and of the actual value discrepancy between the replacement and original engines and parts, was compelling. Analysing BNA's claims one by one, the court found that:

1 the language of Section 5(a) of the lease was not ambiguous and required that the replacement engines would have a "monetary worth and usefulness" at least equivalent to that of the original engines and not less than 1,750 cycles remaining until next scheduled engine overhaul. The fact that the terms "value" and "utility" were not actually defined in the lease was not material to the case.

2 With respect to the parts, the fact that Southwest stripped the aircraft of their valuable engines and parts and replaced them with comparatively inferior parts breached the "value and utility" requirement of Section 8.

3 Southwest failed to offer any evidence to refute the claim that it had breached its 'equal treatment' obligation under Section 7(a).

Accordingly, the court awarded judgment in favour of BNA.

Comment

Although U.S. Bank National Association v Southwest Airlines Companyhas no binding effect under English law, it still bears some relevance because (i) to date there has been no similar case in the UK, and (ii) given the similarities between the rules of interpretation and construction of contracts in the US and in the UK, it is not unlikely that an English court facing a similar set of circumstances would have reached the same conclusion.

Looking at the factual background of the case, it is possible that Southwest were fully aware of the terms of the lease but nonetheless decided that, despite the potential risk, replacing engines and parts so close to the end of the lease term was a viable course of action. Given the flagrant nature of the breach, however, this does not seem very likely. A more plausible explanation is that the decision makers at Southwest either did not have a full copy of the lease to hand or that they simply overlooked the replacement provisions and focused solely on the redelivery provisions. Either way, the decision to replace those parts and engines seems to have cost Southwest considerably.

Moving forward, carriers can learn from this oversight or error of judgement by Southwest by taking the following precautions:

  • Ensure that their aircraft leases contain precise definitions for key terms as well as clearly drafted replacement and redelivery provisions. Where possible, these should be standardised across the fleet.
  • Make the lease agreements available to both engineers and lease managers with the requirement that they use them as a reference throughout the life of lease(s).
  • Make lease managers and fleet and engineering planners work closely together as a matter of course. In particular, require them to align themselves with one another to ensure that any measures taken to maximise the utility and value of engines and components (for example through engine swaps) always comply with the terms of the relevant lease(s).
  • Always seek to return airframes with native engines and parts. If permanent replacement is required, make sure (save in the unlikely event that the lease does not actually require this) that the replacement engine or replacement part has the same, if not better, value and utility as the original engine (for example, in terms of average LLPs life and time since last overhaul) and that your comparative analysis can be substantiated through documentation.
  • Seek legal advice to clarify any lease provision or issue that gives rise to concern or uncertainty in order to make informed decisions.

Otherwise, carriers could find themselves out of pocket having to pay late redelivery charges, reinstatement costs or lessor's compensation that would not necessarily have been provisioned for.

Footnote

1 Order given by U.S. District Court for the Southern District of New York, 20 July 2009

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.

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