United States: The Battle Over Chattel

Does Aircraft Lease Chattel Paper Still Matter After Cape Town?

In an increasingly digital world, the importance of physical paper appears to be on the wane.  With the advent of the Cape Town Convention, an international treaty on recognition of rights in moveable assets ("Cape Town" or the "Treaty"), many in the aviation finance industry hoped that there would no longer be a need for lenders in New York law-based deals to take possession of aircraft lease chattel paper.  According to that line of thinking, lenders expected to be adequately protected at all times as long as appropriate registrations were made on the International Registry of Mobile Assets (the "International Registry"). 

An examination of the scope of Cape Town's applicability, however, reveals that there are actually gaps in coverage in certain situations, with the result that lenders in a New York law-based transaction should insist on taking possession of aircraft lease chattel paper to ensure that all of their rights and interests are protected in the lease at all times. 

Background

Cape Town provides a uniform, international framework for rights and remedies with respect to aviation-related assets, as well as rail and space assets (for purposes of this article, we will disregard rail and space assets and only refer to aviation-related assets).  The Treaty is comprised of two components – the Convention on International Interests in Mobile Equipment (the "Convention") and the Protocol on Matters Specific to Aircraft Equipment (the "Aircraft Protocol").  The Convention is an umbrella text governing transactions involving all asset types.  The Aircraft Protocol is, as its name suggests, the text that applies specifically to aviation-related assets. Unless otherwise noted herein, a reference to Cape Town invokes both the Convention and the Aircraft Protocol.

The Treaty was developed in response to the hesitancy of many lenders to offer financing for aircraft assets, which are easily and often moved from one jurisdiction to another and therefore from one legal system to another, resulting in uncertainty as to financiers' rights and remedies.  By providing a standardized global set of rights and remedies, the drafters of Cape Town hoped to lessen or eliminate such transaction risks and thus encourage financing with respect to moveable assets.  As of September 1, 2015, sixty-eight countries and the European Community have ratified or acceded to the Convention and the Aircraft Protocol, including the United States, and most recently, the United Kingdom. 

The International Registry

Cape Town establishes the International Registry, an entirely electronic, web-based system, for purposes of registering and prioritizing interests (collectively, "Cape Town Interests") in what it refers to as "aircraft objects", which are airframes, aircraft engines and helicopters (herein, "Aircraft Objects").2  Cape Town Interests include ownership interests, security interests, lease interests and conditional sales interests.3

In the case of a collateral assignment of a lease, four registrations are typically made on the International Registry with respect to each Aircraft Object – (1) the contract of sale, (2) the international interest arising under the security agreement, (3) the international interest arising under the lease and (4) the assignment of the international interest in the lease.  For the reasons set forth below, these registrations may not be sufficient to protect the lender's interest in all Components subject to the lease and collaterally assigned by the security agreement. 

What Exactly Qualifies for Protection under Cape Town as an Aircraft Object?

As noted above, Cape Town only applies to Aircraft Objects (for purposes of this article, we will disregard helicopters and only refer to airframes and aircraft engines).  The definition of Aircraft Object under the Treaty also includes all data and manuals related thereto, as well as any accessories, parts or equipment that are installed, incorporated orattached to the airframe or engine ("Installed Components").4

Examples of Installed Components are propellers, auxiliary power units, landing gear, computers and in-flight entertainment systems when they are installed, incorporated or attached to an airframe or aircraft engine.  The Treaty is clear that an Installed Component is not a distinct Aircraft Object that would be separately covered by Cape Town,5 but rather, upon its installation on an airframe or engine, is deemed to be part of that Aircraft Object and becomes subject to any existing registrations on the International Registry with respect to that Aircraft Object.6

So, What Does NOT Qualify? 

The flip side of this general rule of applicability is that Cape Town does not apply to, and does not affect rights or interests in, accessories, parts or equipment of an airframe or engine when such items are NOT installed, incorporated or attached ("Uninstalled Components").  Instead, the Treaty provides that rights and interests in Uninstalled Components are governed by the applicable local law,7 which, for purposes of this article, is Article 9 of the New York Uniform Commercial Code (the "New York UCC") and, if dealing with a U.S.-registered aircraft, possibly the U.S. Transportation Code (and related regulations) as well.

Because the New York UCC bestows a higher priority on the holder of lease chattel paper as compared to perfection by filing a UCC financing statement covering the chattel paper lease,8 financiers should take possession of aircraft lease chattel paper to protect their rights, and to better protect their interests, in any Uninstalled Components. 

A Case Study

To demonstrate the interplay between Cape Town and local law, let's consider the example of an auxiliary power unit (APU) subject to a lease that has been collaterally assigned to a lender.  As previously mentioned, an APU that is installed on the aircraft at the commencement of the leasing and financing will be covered by registrations on the International Registry with respect to the airframe on which the APU is installed, because the APU, by virtue of its status as an Installed Component, is considered to be part of that airframe.

Now, let's consider an APU that has not yet been installed on the airframe at the commencement of the leasing and financing.  Based on a plain reading of Cape Town and the Official Cape Town Commentary, we know that Cape Town does not apply to accessories, parts or equipment prior to their installation on an Aircraft Object.  Thus, the lender must have taken possession of the chattel paper lease to ensure that its rights and interests in the APU (as part of the chattel paper lease) are protected under local law prior to the installation of the APU on the aircraft.

We reach the same conclusion where the APU is removed from an airframe after commencement of the leasing and financing.  For example, consider a lessee who removes the APU for maintenance purposes while the lease is ongoing.  During that time, the lessee files for bankruptcy and there is an event of default under the security agreement.  Cape Town rights and remedies will be available to the lender in respect of the airframe and the aircraft engines, but not in respect of the APU.  However, if the lender has possession of the chattel paper lease, it will be perfected under the New York UCC in respect of chattel paper rights with respect to the APU as against all third party creditors.

Conclusion

It will likely come as a surprise to many that Cape Town does not apply in all situations with respect to major aircraft components.  For that reason, financiers should continue to perfect their interests – whether in chattel paper or the Installed and Uninstalled Components themselves – under both Cape Town and the applicable local law.  Unfortunately, the result for New York law-based transactions is that the need to take possession of chattel paper aircraft leases still very much exists.

Footnotes

1. A special thank you to our New York summer associate, Jeremy Schara (Hofstra Law '16), for his invaluable assistance in researching the material for this article.

2. Cape Town Convention on International Interests in Mobile Equipment and Protocol thereto on Matters Specific to Aircraft Equipment, art. 2, Nov. 16, 2001, 2307 U.N.T.S. 285 [hereinafter "Convention" or "Protocol"]. See Convention, art. 2(3)(a).

3. Convention, art. 2(2).

4. Protocol, art. I(b) & (e) (defining aircraft engines and airframes, respectively).

5. Professor Sir Roy Goode C.B.E., Q.C., Cape Town Convention and Aircraft Protocol Official Commentary (Third Edition), UNIDROIT 2013, §3.9.

6. Id.

7. Id. at § 4.195.

8. N.Y. U.C.C. § 9-330.

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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