Operating leases: Olympic Airways Judgment

Executive summary

In May 2010 we reported on the application for summary judgment in ACG Acquisition XX LLC v Olympic Airlines S.A. [2010] EWHC 923 (Comm). The case has attracted considerable attention from the aviation community as it concerns the circumstances in which the defective condition of an aircraft under an operating lease might entitle the airline to refuse to pay rent for it.

The English High Court delivered its judgment⁴ in the full trial. The judgment of the court reinforces the need for careful drafting of operating leases and has important implications for both lessees and lessors which we consider further in this briefing. We consider some of the issues surrounding delivery condition, airworthiness and the contractual protections typically found in operating leases. Whilst the court found in favour of the Lessor, the case must be viewed in the context of its particular set of facts, and the exact drafting of the clauses considered by the court. The case also emphasises the need for lessees to satisfy themselves as to the condition of the aircraft at delivery and to recognise that they may bear the risk of any defects discovered thereafter.

Background

In 2008, ACG Acquisition XX LLC (Lessor) entered into an operating lease with Olympic Airlines SA (Lessee) under which it agreed to lease a Boeing 737-300 aircraft for a term of five years, following redelivery of the aircraft from AirAsia. The Lessor undertook that the aircraft would be airworthy and that it would comply with the detailed requirements specified in the lease as to the condition of the aircraft on delivery (Delivery Condition).

The aircraft was delivered on 19th August 2008. The Lessee signed a certificate of acceptance, which, under the lease, was formally deemed to constitute delivery. The aircraft then went into service on 23rd August 2008. The Hellenic Civil Aviation Authority (the CAA) duly became the competent authority for the aircraft and granted the aircraft a certificate of airworthiness.

On 6th September 2008, just 15 days after it entered into service, the aircraft was grounded when cables that controlled the spoilers on one wing were found to be broken. While trying to repair the broken cables, the Lessee discovered 14 separate categories of defects, including defects which affected other flight control surface mechanisms such as the ailerons. The state of the aircraft was such that, on 11th September 2008, the CAA took the step of withdrawing the aircraft's certificate of airworthiness. Even after the aircraft had spent months at Europe Aviation, a maintenance and repair organisation nominated by the Lessor, the CAA still refused to grant it a certificate of airworthiness. The Lessee claimed that the cost of the work which would be required to render the aircraft airworthy would exceed the value of the aircraft and this claim was not challenged by the Lessor.

Application for summary judgment

In September 2009, the Lessor issued proceedings against the Lessee for payment of the outstanding rent and maintenance reserves under the lease and for damages. The following day, the Lessee issued a claim against the Lessor seeking damages for breach of the lease, in particular the provisions relating to the delivery condition of the aircraft. In February 2010 the Lessor applied for summary judgment in relation to both claims.

The court dismissed the Lessor's application for summary judgment, holding, amongst other things, that the Lessee had established an arguable case that (i) the failure by the aircraft to comply with the Delivery Condition was such as to place the Lessor in breach of contract allowing the Lessee to claim damages (notwithstanding the standard lessor protections in the lease and the terms of the certificate of acceptance) and (ii) the aircraft was in such a bad condition at delivery that there had been a complete failure of consideration. For more details on the summary judgment, please see here. The case then proceeded to full trial.

The Lessor's case at full trial

In its claim for the payment of rent and maintenance reserves, the Lessor argued that the aircraft was delivered to and accepted by the Lessee and that the condition of the aircraft conformed with the requirements of the lease, in particular that the aircraft was airworthy. Alternatively, the Lessor argued that if the aircraft was not airworthy, the Lessee was estopped by the terms of the certificate of acceptance or by law from asserting that it was not delivered in accordance with the terms of the lease. The Lessor also claimed that the Lessee's failure to pay rent or maintenance reserves was a repudiatory breach of the lease.

The Lessee's case at full trial

The Lessee claimed that the aircraft was not delivered in the condition required by the lease and, in particular, was not airworthy. The Lessee also claimed that it was not estopped from claiming damages for that breach by the terms of the certificate of acceptance. The Lessee put forward three main arguments to counter the Lessor's claim for payment of rent and maintenance reserves:

• that in consequence of the aircraft not being delivered in the condition required by the lease and, in particular, not being airworthy, the Lessee had never been obliged to pay rent or maintenance reserves and was entitled to claim damages from the Lessor for breach of the lease;
• alternatively, that it was entitled to claim back rent and maintenance reserves on the grounds of a total failure of consideration; and
• in the further alternative, that the lease was frustrated by the suspension of the aircraft's certificate of airworthiness.

The decision at full trial

The court dismissed the Lessee's claims and found in favour of the Lessor. Whilst the court accepted that the aircraft was, in breach of the lease, not in an airworthy condition on delivery, the court held that:

• by virtue of the confirmations given in the certificate of acceptance the Lessee was estopped from making a claim for damages and from claiming that it was never obliged to pay rent or maintenance reserves;
• by virtue of the fact that the Lessor had delivered possession of the aircraft to the Lessee, and the fact that the Lessee was estopped from alleging that on delivery the aircraft was not in the Delivery Condition, the Lessee could not establish a total failure of the performance for which it had bargained; and
• the lease was not frustrated on account of withdrawal of the certificate of airworthiness.

The decision of the court is analysed in further detail below.

Key contractual provisions

Clause 4.2 of the lease set out a positive obligation on the Lessor to deliver the aircraft "as is, where is" and in the condition required in Schedule 2.

Clause 7.9 of the lease contained a "conclusive proof clause" in the following terms

"delivery by Lessee to Lessor of the certificate of acceptance will be conclusive proof as between Lessor and Lessee that Lessee has examined and investigated the aircraft, that the aircraft and the aircraft documents are satisfactory to Lessee and that Lessee has irrevocably and unconditionally accepted the aircraft for lease hereunder without any reservations whatsoever (except for any discrepancies which may be noted in the certificate of acceptance)."

Schedule 2 to the lease set out that the aircraft would be in a specified condition at delivery, including that the aircraft would be airworthy.

The judgment of the court must be read in the context of this particular set of facts and the above contractual provisions. As mentioned in our previous briefing, parties (and in particular lessors) should exercise caution when referring to the condition of the aircraft at delivery, as any such references may be interpreted as cutting across the "as is, where is" nature of the transaction, and imposing a continuing obligation on one or other party. Requirements as to the condition of the aircraft at delivery should be expressed as conditions precedent and not as undertakings, such that they express a state of affairs which, if true, binds the lessee to accept the aircraft.

The definition of "airworthiness"

Significantly, in determining whether the aircraft complied with the Delivery Condition, the court considered what was meant by the term "airworthiness". The court was not aware of any previous authority which considered the meaning of such term and both the Lessor and Lessee put forward their own formulations: the Lessor contending that an aircraft was airworthy if the aircraft had been properly maintained notwithstanding that there existed a defect which, had the operator known of it, would have prevented the aircraft from flying, and the Lessee contending that an aircraft was only airworthy if it was safe to fly.

Whilst the court appreciated that it should be cautious in drawing analogies between ships and aircraft, and in the absence of any authority relating to airworthiness, it could not see any reason for understanding airworthiness in a materially different manner from seaworthiness. On that basis, the court held that the test as to whether an aircraft is airworthy is:

Would a prudent operator of an aircraft have required that the defect should be made good before permitting the aircraft to fly, had he known of it. If he would the aircraft was not airworthy.

It is important to note that this is a question of fact at the material time and does not depend on whether a particular defect was known by either party. As references to airworthiness in English law documentation should now be construed in light of the above definition, lessors need to exercise caution in undertaking that any aircraft is airworthy. In the absence of adequately drafted lessor protections, including the exclusions and disclaimers of liability, the "as is, where is" provision and the hell and high water clause, it is not difficult to imagine a lessor being found liable for damages for breach of a lease on the basis that the aircraft was not in fact airworthy at delivery.

The Lease and the Certificate of Acceptance

The certificate of acceptance, which was signed by both parties and was an "Operative Document" for the purposes of the lease, was given prominence in the court's judgment. The certificate contained a confirmation by Olympic that the aircraft and aircraft documents "complied in all respects with the condition required at delivery under Section 4.2 and Schedule 2 of the Agreement".

The court held that it would be inequitable for the Lessee to be permitted to allege, contrary to the clear and unequivocal representation set out above, that the condition of the aircraft on delivery did not comply with the Delivery Condition set out at Schedule 2 to the lease.

In making that finding, the court relied upon the principle of estoppel by representation. This principle operates to prevent a party who has made a representation of fact which has induced the other party to act to his detriment in reliance upon that representation from later acting inconsistently with that representation.

The court placed emphasis on the fact that the Lessee had had the opportunity to inspect the aircraft and had the right to require one or more acceptance flights prior to delivery. In addition, the Lessee was aware that the certificate of acceptance would be signed prior to the Lessor's acceptance of redelivery from AirAsia, and of the Lessor's reasons for adopting such procedure. The Lessor, in reliance upon the representation made in the certificate of acceptance signed by the Lessee, accepted redelivery of the aircraft from AirAsia and in doing so, acted to its detriment in giving up its right to refuse to accept redelivery of the aircraft on account of the aircraft's condition.

It is important to note that the conclusive proof clause, as drafted, did not have the effect of precluding a claim for damages for breach by the Lessor of its obligation to deliver the aircraft in the Delivery Condition. In the absence of a direct reference to clause 4.2 of, and Schedule 2 to, the lease, the court held that the conclusive proof clause operated only as a waiver of any right the Lessee might otherwise have had to refuse to accept the aircraft, a right distinguishable from the right to claim damages for breach of the lease.

For lessors, co-ordinating the redelivery of an aircraft from its existing lessee with the delivery to its future lessee is of paramount importance. The lessor does not want to find itself having accepted redelivery without assurance that the aircraft will be accepted by its future lessee, with the effect that the aircraft is on the ground and is not generating revenue for the lessor and, potentially, that the aircraft requires costly maintenance work in order to put it into the condition required by the future lessee. Whilst clearer drafting would also assist, lessors may consider adopting the above redelivery/delivery acceptance procedure and advising the lessee of the reasoning behind such procedure. Had the Lessor not done so, the Lessee may have succeeded in its claim as the elements required to rely on the principle of estoppel by representation would not have been satisfied.
According to the court, the fact that there might be hidden defects which could not be detected by the Lessee by means of its pre-delivery inspection did not make it inequitable to prevent the Lessee's claim, because it would have been appreciated by the Lessee before signature of the lease and the certificate of acceptance that such hidden defects might exist. This leaves lessees in an unattractive position, as, in practice, lessors will not grant future lessees unlimited rights of inspection of an aircraft or its documents. Following this judgment, it is clear that, whilst it is important for lessees to obtain the right to inspect the aircraft and its documents, and to observe an acceptance flight, they may bear the risk of any defects being discovered after delivery.

Frustration

Of particular note, in its consideration of whether the lease was frustrated, is the court's consideration of the parties' expectations as to risk in the context of a pure operating lease. The court concluded that the lease was not frustrated on account of withdrawal of the certificate of airworthiness, the risk of such withdrawal being a risk assumed by the lessee. In determining with whom such risk properly lay, the court placed reliance on the so called "hell and high water clause" which provided, in summary, that the Lessee's obligation to pay rent was absolute and unconditional irrespective of any right of set-off or any defect in the airworthiness of the aircraft.

Conclusions and practical considerations

The case reinforces the importance of careful negotiation and drafting of operating leases for both lessors and lessees, in particular the provisions dealing with delivery condition, airworthiness and the lessor's contractual protections. Whilst lessors can take some comfort from this case, the judgment must be viewed against the particular set of facts, and the availability of the principle of estoppel by representation on these facts. The exact wording of the Lessee's representation in the certificate of acceptance was an important factor for the court. Also, whilst the Lessor could not rely on the conclusive proof clause in this case, the judgment suggests that the court's interpretation of that clause might have been different had it contained a direct reference to the Lessor's obligation to deliver the aircraft in the Delivery Condition. For lessees, the case demonstrates the need for sufficient opportunity to inspect the aircraft and its records and to conduct an acceptance flight prior to delivery and to recognise that it may bear the risk of any defects discovered after delivery.
We shall provide you with an update should an appeal be brought in the English courts. In the interim, please do not hesitate to contact us should you require any assistance in negotiating and drafting your operating leases or have any concerns as a result of this judgment.

Footnotes

⁴ACG Acquisition XX LLC v Olympic Airlines (in special liquidation) [2012] EHWC 1070 (Comm.)

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.