Register to receive a printed copy(For Lexis Practice Advisor® Subscribers Only)
Lexis Practice Advisor®Free Trial
Learn More AboutLexis Practice Advisor®
By: Patrick Dolan and Ramy Ibrahim, Norton Rose Fulbright Us LLP
THE AIRCRAFT LEASE SECURITIZATION MARKET IS EVOLVING as evidenced by an increase in these transactions over the last few years. Indications are that 2017 may surpass 2016 in total number of aircraft lease securitizations. Three potentially significant issues for the aircraft lease securitization market during 2017 and in 2018 are (1) the applicability of the U.S. risk retention rule (Risk Retention Rule; see 79 FR 77602) to aircraft lease securitizations, (2) the U.S. Commodity Futures Trading Commission’s rules regarding margin requirements for uncleared swaps, and (3) compliance with the Volcker Rule.
This article explains the structure of aircraft lease securitizations and certain bankruptcy and rating agency issues that must be considered in structuring these transactions, the benefits of using the debt capital markets for aviation financing, and the issues for the aircraft lease securitization market during 2017 and in 2018.
Aircraft lease securitizations generally come in two types: aircraft lease portfolio securitizations and enhanced equipment trust certificate (EETC) securitizations.
The diagram below shows the structure of a typical aircraft lease portfolio securitization:
The diagram below shows the structure of a typical EETC aircraft lease securitization:
In both aircraft lease portfolio securitizations and EETC aircraft lease securitizations, there is a liquidity facility provided by a highly rated bank to ensure the payment of interest during an aircraft remarketing period (up to 18 months) following a default by an airline lessee. In EETC aircraft lease securitizations involving U.S. airlines, the lessor would typically rely on Section 1110 of the U.S. Bankruptcy Code, 11 U.S.C. § 1110, to repossess an aircraft from a bankrupt lessee. Section 1110 permits a lessor to repossess an aircraft if the bankrupt lessee does not elect to assume the lease and cure all defaults within 60 days of the bankruptcy filing.
In both types of securitizations, the lessor will typically grant possessory and security rights to a security or indenture trustee, which will represent and act on behalf of the noteholders. Following a default, the trustee will have the ability to enforce legal and contractual remedies against such rights in accordance with the relevant law and security agreement. The types of rights pledged to the trustee often include:
This trustee arrangement allows for trustee companies experienced in aircraft lease securitizations to centralize the decision-making process for several noteholders and to protect the rights and interests of those noteholders without requiring them to develop industry expertise.
In an EETC aircraft lease securitization or an aircraft lease portfolio securitization involving the bankruptcy of a foreign airline, Section 1110 of the U.S. Bankruptcy Code would not be available. Instead, the lessor would have to rely on the 2001 Cape Town Convention and its Aircraft Equipment Protocol (collectively, the Cape Town Convention) discussed later under Insolvency Issues. Finally, prior to the 2008 credit crisis, monoline insurance companies often provided bond insurance for bonds issued in aircraft lease securitizations. Since the credit crisis, however, aircraft lease securitizations no longer have this feature but rather rely on, among other things, over-collateralization
The sponsor or an affiliate of the sponsor is normally the servicer in an aircraft lease securitization. In an aircraft lease portfolio securitization, it is not unusual to have two issuers of the bonds, a Delaware issuer and a Cayman Island issuer, and local law mortgages are not filed against the aircraft. Aircraft lease securitizations also often have many of the following features:
While in theory it is possible to have an EETC aircraft lease securitization involving a non-U.S. airline as the sponsor, these transactions are not common. A feature found in recent aircraft lease portfolio securitizations is the sale of the residual or equity interest in the transaction to third-party investors. Previously, this interest was retained by the sponsor.
As noted above, in an aircraft lease portfolio securitization most of the lessees are airlines located outside the United States and Section 1110 of the U.S. Bankruptcy Code is not available to the issuer in the securitization. The Cape Town Convention permits countries to select one of two options for dealing with airlines in bankruptcy:
Alternative A provides that upon the occurrence of an insolvency-related event, the bankrupt debtor must give possession of an aircraft to the related creditor no later than the earlier of (1) the end of the “waiting period” and (2) the date on which the creditor would be entitled to possession of the aircraft if the Cape Town Convention did not apply. The waiting period is defined in the Cape Town Convention as the period specified in a declaration of the ratifying state/jurisdiction, which is the primary insolvency jurisdiction. States interested in achieving efficient pricing for financings and securitizations of aircraft have typically adopted a waiting period of 60 days (some states, like Brazil, have adopted a shorter period of 30 days).
In non-Cape Town Convention countries, investors must determine whether there are protections in the jurisdiction of the lessee for creditors in an airline bankruptcy similar to those contained in Section 1110 of the U.S. Bankruptcy Code.
Some of the factors that a rating agency will consider in rating an aircraft lease securitization include:
The rating agencies will typically require satisfactory appraisals of the aircraft prior to closing and may also require a maintenance appraisal showing projected maintenance expenses for the aircraft portfolio being securitized
The rating agencies will also consider the following factors:
There are several benefits to sponsors in accessing the U.S. debt capital markets by means of an EETC aircraft lease securitization or aircraft portfolio lease securitization. First, the capital markets should generally be able to provide cheaper financing than the bank financing market and accommodate larger transactions. By using securitization structures, noninvestment grade airlines or aircraft lessors are able to issue investment grade debt. Also, by accessing the capital markets, the sponsor airlines or aircraft lessors are able to gain exposure to new lenders and investors. Finally, the negative covenants in an aircraft securitization are generally less restrictive than those in a typical bank financing. This is in part because in a Rule 144A offering, which is how most aircraft securitizations access the U.S. capital markets, investors normally hold their securities in uncertificated form through the Depository Trust Company, and this makes it difficult to obtain an amendment or waiver of the transaction documents after closing so the covenants have to be drafted so as to allow for flexibility.
The Risk Retention Rule requires that the sponsor of any securitization transaction retain an economic interest in the credit risk of the securitized assets. The sponsor is the party that initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity. A securitization transaction is a transaction involving the offer and sale of asset-backed securities (defined below in Defined Terms) by an issuing entity. The sponsor of a securitization transaction must retain an eligible vertical interest or eligible horizontal residual interest, or any combination thereof as follows:
The percentage of the eligible vertical interest, the eligible horizontal residual interest, or combination thereof retained by the sponsor must be determined as of the closing date of the securitization transaction. In lieu of retaining all or any part of an eligible horizontal residual interest, the sponsor may, at closing of the securitization transaction, cause to be established and funded in cash, an eligible horizontal cash reserve account in the amount equal to the fair value of such eligible horizontal residual interest or part thereof, subject to certain specified conditions. The Risk Retention Rule contains specific provisions for alternative modes of risk retention for certain asset types (e.g., commercial mortgage-backed securitizations, credit card securitizations, asset-backed commercial paper, etc.).
“Asset-backed security” is defined by incorporation of the definition of asset-backed security in the U.S. Securities and Exchange Act of 1934 (Exchange Act) and reads in relevant part as follows:
a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset . . . [emphasis added]. See 15 U.S.C. § 78c(a)(79).
“Asset-backed security interest” is defined in the Risk Retention Rule, in relevant part, as:
[a]ny type of interest or obligation issued by an issuing entity, whether or not in certificated form, including a security, obligation, beneficial interest, or residual interest . . . payments on which are primarily dependent on the cash flows of the collateral owned or held by the issuing entity….
Additional questions regarding risk retention requirements are included in the full practice note in Lexis Practice Advisor.
In the event the Risk Retention Rule does apply to a transaction, it provides that the required 5% retained interest may be held by a “majority-owned affiliate” (MOA) of the sponsor. A MOA of a person is an entity (other than the issuing entity) that directly or indirectly majority controls, is majority controlled by, or is under common majority control with, such person.
“Majority control” is defined to mean ownership of more than 50% of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under generally accepted accounting principles.
The securitization industry appears to have settled on an 80-20 rule for MOAs that hold a vertical risk retention interest: up to 80% of the economic interest in the MOA may be sold to third parties so long as the sponsor retains 20% of the economic interest in and a majority of the voting control of the MOA. Apparently, at least one of the leading U.S. accounting firms is in agreement with this approach. The MOA-vertical retained interest approach is used in the collateralized loan obligation sector, but apparently has not been used in other sectors of the securitization market, although there is no reason why it cannot be used in other sectors. This 80-20 approach has apparently not been used in the context of an MOA holding an eligible horizontal residual interest. It is worth noting that the staff of the Securities and Exchange Commission (SEC) has suggested, in informal conversations, that the farther one moves away from the sponsor holding a majority economic interest in the MOA, the more one needs to be cognizant of the anti-hedging provisions in Section 12(b) of the Risk Retention Rule.
Full recourse financing of the risk retention interest by a sponsor or an MOA is permitted under the Risk Retention Rule. There is a question, however, as to what full recourse financing means. For example, if the MOA has no assets other than the retained interest, then the full recourse financing requirement probably is not satisfied. Rather, the MOA would have to pledge other assets or obtain a parent guaranty. However, one can make the case that in the context of a vertical retained interest (i.e., 5% of each class), 5% of the most senior class of classes will likely constitute most of the retained interest and in that situation, the parent guaranty could be limited (e.g., 5%).
Saudi Arabia recently decided to comply with the Risk Retention Rule in a sukuk bond offering of about $10 billion. This was apparently the first time a sukuk bond offering had complied with the Risk Retention Rule. In the offering memorandum, Saudi Arabia disclosed that it did not intend for its sukuk offering to be a securitization but as a precaution, it decided to comply with the Risk Retention Rule and retain a 5% eligible vertical interest. To comply with Shari’a law, the transaction used a murabaha or commodities purchase agreement involving a deferred purchase price structure where the deferred purchase price payments match the payments due on the related bonds offered to investors. The lawyers for Saudi Arabia apparently spoke to the SEC staff about the applicability of the Risk Retention Rule to the transaction. The staff may not have agreed that the murabaha or commodities purchase structure used in the transaction to comply with Shari’a law was not a self-liquidating financial asset.
The possibility of a sukuk tranche in an aircraft lease securitization also raises potential Risk Retention Rule issues. There are generally four common structures used in sukuk bond offerings (and there are variations of each of these structures) in order to make the transaction compliant with Shari’a law. The structure that poses the most challenges for purposes of the Risk Retention Rule involves the use of a commodities purchase arrangement involving deferred purchase price payments, or a murabaha structure, where the deferred purchase payments match the payments due on the related aircraft securitization bonds. While the structure is used to make the transaction compliant with Shari’a law, it is possible to view the deferred purchase price arrangement or a murabaha structure as a self-liquidating financial asset for purposes of the definition of asset-backed security under the Risk Retention Rule. A strong counterargument is that in a murabaha structure, there is no third-party credit risk being transferred. This is, however, a policy argument rather than an argument based on the text of the Risk Retention Rule.
Another argument for the proposition that the Risk Retention Rule should not apply to sukuk offerings is based on an SEC staff compliance and disclosure phone interpretation issued September 6, 2016, regarding funding agreement-backed notes (see SEC Staff Compliance & Disclosure Interpretation (CD&I) Section 301, September 6, 2016). The phone interpretation involved the following facts:
The question presented to the staff was whether such funding agreement-backed notes would be an asset-backed security as defined in 15 U.S.C. § 78c(a)(79). The staff responded that they would not because they did not consider the funding agreement to be a separate financial asset servicing payments on the notes. Rather, an assessment of the cash flows servicing the payments on the notes requires looking through the funding agreement to the general account of the insurance company because (1) the structure of the funding agreement-backed notes is meant to replicate payments made by the insurance company under the funding agreement, (2) the funding agreement is a direct liability of the insurance company, and (3) payments on the funding agreement-backed notes are based solely on the ability of the insurance company to make payments on the funding agreement. Some have argued that the foregoing SEC staff phone interpretation provides a basis for arguing certain sukuk structures should not be subject to the Risk Retention Rule. It should be noted that SEC staff phone interpretations are not binding and therefore do not have precedential value.
It is not clear what remedies the U.S. government or private parties may pursue for violations of the Risk Retention Rule since the rule does not address this issue. The applicable U.S. governmental agencies charged with jointly administering the rule (the U.S. Office of the Comptroller of the Currency (OCC), the U.S. Federal Reserve System, the U.S. Federal Deposit Insurance Corporation (FDIC), and the SEC), however, will have the power to seek and impose penalties against sponsors who violate the Risk Retention Rule. The rule provides that the rule and any related regulations shall be enforced by the appropriate federal banking agency, with respect to any securitizer that is an insured depository institution, and the SEC with respect to any securitizer that is not an insured depository institution. Private rights of action for violations of the rule could include disclosure-based litigation claims against issuers and underwriters and rescission claims by investors.
The stakes for noncompliance with the Risk Retention Rule are potentially significant.
Another potential issue facing the aircraft lease securitization market is the Commodity Futures Trading Commission (CFTC) swaps margin requirements for uncleared swaps that went into effect on March 1, 2017. Pursuant to the Commodity Exchange Act, the CFTC is required to promulgate margin requirements for uncleared swaps applicable to each swaps dealer for which there is no prudential regulator (i.e., the swaps dealer is not regulated by the Board of Governors of the Federal Reserve System, the OCC, the FDIC, the Farm Credit Administration, or the Federal Housing Finance Agency)1 . The CFTC published final margin requirements for swaps dealers in January 2016. As part of the final margin requirements, the CFTC issued Regulation 23.153, which requires swaps dealers to collect and post variation margin with each counterparty that is a swaps dealer, major swap participant, or a financial end user. On February 13, 2017, the CFTC extended the compliance date for variation margin requirements from March 1, 2017 to September 1, 2017.
An aircraft lease securitization warehouse facility where the borrower is an SPE that purchases receivables, loans, or leases with borrowings under the warehouse facility may not be able to find an exclusion from the definition of financial end user in the margin rule. Clause (xi) of the definition of “financial end user” is very broad.
Consequently, an SPE borrower in an aircraft lease warehouse facility would appear to be required to post margin for an interest rate hedge. This is not practical since the SPE borrower is unlikely to have the ability to post such margin. The same issue applies to aircraft lease securitizations that employ a swap in the transaction.
One possible solution for the SPE borrower is to enter into an interest rate cap, but caps can be expensive. Another possible solution is to obtain a liquidity facility to cover margin requirements, but that may raise bankruptcy true sale issues if there is recourse to the originator under the liquidity facility.
Another possible approach is the treasury affiliate exemption. This exemption is available if the SPE borrower forms a subsidiary whose sole purpose would be to enter into the swap, which would be guaranteed by the parent SPE borrower. This approach is based in part on a CFTC no-action letter dealing with the treasury exemption in the context of the clearing rules. This no-action letter predates the uncleared swap margin rules, but there is language in the CFTC final swap margin rules that supports extension of the no-action letter to the margin rules. One caveat to this approach is that the parent of the treasury affiliate cannot be majority owned by a “private fund” (a company that would be an investment company but for Sections 3(c)(1) or 3(c)(7) of the Investment Company Act).
The Volcker Rule is the rule that implements Section 619 of the Bank Holding Company Act that was added by the Dodd-Frank Consumer Protection Act. An SPE issuer in an aircraft lease securitization will generally be deemed to be a “covered fund” under the Volcker Rule unless it can rely on an exemption from the Investment Company Act of 1940, other than Sections 3(c)(1) or 3(c)(7). A covered fund is subject to numerous requirements under the Volcker Rule and securitizations are normally structured so as to avoid relying on those two exemptions.
The good news for the aircraft lease securitization market is that the OCC recently published a Request for Comment (RFC) asking for industry input as to how the Volcker Rule can be improved. The questions in the RFC fall into four categories:
The questions in the RFC suggest that the OCC is likely to push for significant modifications to the Volcker Rule. While the Volcker Rule cannot be modified by the OCC alone but must include the consent of the other agencies who originally issued the Volcker Rule, the RFC suggests that there may be some relief in the future for SPE issuers in aircraft lease securitizations.
Some issues that have come up in recent transactions include the following:
The aircraft lease securitization market is an evolving one and the transaction structure issues continue to be interesting.
Patrick D. Dolan is a partner with Norton Rose Fulbright. He focuses his practice on asset-backed and mortgage-backed securitizations, including those involving innovative structures. Patrick has more than 30 years of experience representing warehouse lenders, issuers, underwriters, investors, and multi-seller commercial paper conduits. Patrick has worked on financings and securitizations of various asset types. Patrick chairs the New York City Bar Association's Structured Finance Committee. Ramy Ibrahim is an associate in Norton Rose Fulbright's New York office. He focuses his practice on finance and M&A, helping clients in the financial institutions, technology, energy, transportation, and innovation industries. His background includes corporate finance, private and public mergers and acquisitions work, and equipment finance.
To find this article in Lexis Practice Advisor, follow this research path:
RESEARCH PATH: Finance > Market Trends and Insights > Expert Insights > Practice Notes
For more information about offerings of investment grade asset-backed securities, see
> LEARNING THE BASIC LEGAL FRAMEWORK OF A SECURITIZATION TRANSACTION
RESEARCH PATH: Finance > Structured Finance and Securitization > Securitization > Practice Notes
> INTRODUCTION TO SECURITIZATION
For a discussion on the roles that transaction parties play in packaging and servicing the underlying financial assets supporting asset-backed securities, see
> UNDERSTANDING THE MAJOR PARTIES AND DOCUMENTS IN A SECURITIZATION TRANSACTION
For guidance on the requirements that an issuer of a securitization transaction must meet in order to achieve bankruptcy remoteness, see
> ACHIEVING BANKRUPTCY REMOTENESS IN SECURITIZATIONS
For more information on margin requirements for uncleared swaps, see
> MARGIN REQUIREMENTS FOR SWAPS AND SECURITY-BASED SWAPS
RESEARCH PATH: Finance > Financial Derivatives > Understanding Financial Derivatives > Practice Notes
1. See CFTC Letter No. 17-11, February 13, 2017.