ARTICLE
10 February 2012

Recent Litigation Affecting Aircraft Finance And The Aviation Industry

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Jones Day

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Airlines and aircraft lessors would be well advised in today's economic climate to remain attuned to litigation outcomes that may affect the traditional rules for aircraft financing.
United States Transport
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Airlines and aircraft lessors would be well advised in today's economic climate to remain attuned to litigation outcomes that may affect the traditional rules for aircraft financing. Courts have recently decided cases involving applicability of insurance clauses in lease agreements, interpretation of lease terms controlling parties' obligations, lessors' rights upon default, lease obligations following bankruptcy, and the enforceability of liquidated damages provisions in lease contracts.1

Insurance Clauses in Lease Agreements

When a lessee breaches a lease, interpretation of an insurance clause may prove key to the lessor's attempts to mitigate damages. In Fleet Business Credit L.L.C. v. Global Aerospace Underwriting Managers, Ltd., 646 F. Supp. 2d 473, 475 (S.D.N.Y. 2009), the lessee, after filing for bankruptcy, intentionally removed component parts from the aircraft financed by the plaintiff lessors. Subsequently, the lessors submitted claims for the missing parts to the lessee's insurance broker. Although a plain reading of the lessee's insurance policy provided that intentional acts were not covered under the policy, the plaintiff lessors argued that although the lessee intentionally removed the parts, the removal was "accidental" in relation to the plaintiffs. The lessors also cited to the "Airline Finance/Lease Contract Endorsement" clause (also known as the AVN 67B or 67C Endorsement), providing that the coverage for each contract party under the policy would not be invalidated by any act or omission of any other person or party that results in a breach of the policy.

The district court rejected the lessors' argument, explaining that the scope of the policy's coverage was unambiguous and did not cover intentional acts. Thus, the interpretation and applicability of the "Airline Finance/Lease Contract Endorsement" clause was a secondary issue that would be relevant only to the lessors' attempt to recover their losses from the lessee's insurance policy if the policy's terms were ambiguous with respect to coverage of intentional damage. Accordingly, the court granted the insurance company's motion for summary judgment with respect to the component parts that were intentionally removed by the lessee's employees.

Interpretation of Lease Terms Controlling Parties' Obligations

Consistently and unambiguously defining contract terms in an aircraft lease such that there is little room for more than one legitimate interpretation remains an important issue. In Wells Fargo Bank Northwest, N.A. v. US Airways, Inc., No. 650500/09, 2011 WL 1107127, at *1, (N.Y. Sup. Ct. Mar. 21, 2011), the parties disagreed over the term "delivery" where the defendant was obligated to return the leased aircraft weighing the same "as at delivery." According to the plaintiff, the term referred to the weight of the aircraft at the beginning of the lease. However, the defendant claimed the definition of the term varied in the contract depending upon whether the term was capitalized, alleging that when the term was capitalized, it referred to delivery of the aircraft at the beginning of lease, but when the term was not capitalized, it referred to delivery from the manufacturer. After analyzing the lease agreements, the court noted that the agreements never referenced delivery from the manufacturer. Thus, the court concluded that "delivery" referred only to the beginning of the lease and granted plaintiff summary judgment on liability.

Similarly, in Addison Express, L.L.C. v. Medway Air Ambulance, Inc., No. Civ. 3:04-CV-1954-H, 2006 WL 1489385, at *1 (N.D. Tex. May 19, 2006), Addison Express ("ADEX"), the lessee, attempted to argue that a 24-month lease term required Medway, the lessor, to make "twenty-four separate consecutive deliveries" of the aircraft.2 Medway delivered the aircraft to ADEX in October 2003, and ADEX took possession of the aircraft at that time. The following summer, the United States Drug Enforcement Agency ("DEA") instructed Medway to cease all activity with regard to the aircraft. Though ADEX subsequently obtained a conditional release from the government, Medway notified ADEX that it was terminating the lease as a result of the seizure. ADEX filed suit, claiming that Medway had breached the lease contract by failing to make the required payments after the aircraft was seized. Medway argued that "delivery" failed after the aircraft was seized by the DEA. However, the court rejected Medway's argument, explaining that the lease required "a single delivery of a single good," and that ADEX fulfilled its delivery obligation when it delivered the aircraft to Medway in October 2003.

While consistently and unambiguously defining contract terms in an aircraft lease is important, Addison Express v. Medway Air Ambulance also illustrates that litigation may often be inevitable despite unambiguous lease terms. In addition to asserting that the lease required 24 separate deliveries, Medway also attempted to convince the court that its failure to insure the aircraft against government seizure did not constitute a breach of the lease contract and ultimately an act of default. Medway's president asserted that he interpreted a specific clause in the lease to make seizure insurance optional. The language at issue provided that in the event that the aircraft was seized and "there exists no valid and collectible insurance under any insurance policy," Medway would pay ADEX a lump sum in addition to any other damages or remedies available at law or in equity.3 The court concluded that the language, rather than relieving Medway of its obligation to obtain insurance, "expressly reserves ADEX's right to pursue legal remedies for breach, without excluding default for failure to buy insurance."4

Lessors' Rights Upon Default

In Canal Air, L.L.C. v. William B. McCardell, No. 11-11081, 2011 U.S. Dist. LEXIS 123572 (E.D. Mich. Oct. 26, 2011), defendants voluntarily relinquished their possession of the leased aircraft after defaulting on their payment obligations. Canal Air subsequently sold the aircraft and filed a lawsuit against defendants in order to recover the deficiency and attorneys' fees. Canal Air moved for summary judgment, but defendants alleged that summary judgment was not appropriate because Canal Air failed to establish that disposal of the aircraft was "commercially reasonable" or that it provided defendants reasonable notice prior to the sale. The lease agreement provided that Canal Air could sell the aircraft with or without notice in the event of default. However, despite this unambiguous language, the court denied Canal Air's motion for summary judgment. The court explained that New York law provides that a debtor's rights to a commercially reasonable sale and notice prior to the sale cannot be waived prior to default. Thus, the language in the lease did not constitute a valid waiver of the defendants' statutory rights.

Two recent cases have illustrated that lawsuits seeking to pierce the corporate veil in an effort to find all liable parties after a lessee defaults may be unsuccessful unless the lessor asserts a claim of fraud. The cases also suggest that establishing the existence of fraudulent conduct, a fact-intensive issue, may be difficult. In NetJets Aviation, Inc. v. Peter Sleiman Development Group, L.L.C., No. 3:10-cv-483-J-32MCR, 2011 U.S. Dist. LEXIS 114081, at *1 (M.D. Fla. June 13, 2011), plaintiffs operated a fractional ownership program that allowed multiple individuals or entities to co-lease aircraft. A corporation, J.Ward, purchased and leased fractional interests in two airplanes but failed to make the required payments. After receiving a judgment against J.Ward, plaintiffs discovered, among other things, that Jennifer Ward was the sole shareholder of J.Ward; that one of the defendants lived with Jennifer Ward; that one of the defendants gave money to J.Ward without loan arrangements or agreements; and that the defendants used J.Ward to execute contracts with plaintiffs in order to access and use aircraft without being liable for the services. Thus, plaintiffs alleged that Jennifer Ward ran J.Ward for the benefit of the defendants and sought to pierce the corporate veil.

Defendants filed a motion to dismiss, alleging that plaintiffs had failed to establish that either defendant was an alter ego of J.Ward or that the corporate form was used fraudulently or for an improper purpose. The magistrate judge concluded that the defendants could be considered the alter ego of J.Ward even though they were not shareholders of J.Ward, but he concluded that the allegations regarding the defendants' interactions with J.Ward were insufficient to constitute fraudulent or improper conduct. Thus, the magistrate judge recommended that defendants' motion to dismiss be granted. However, after reviewing the facts, the district court judge concluded that it was premature to foreclose the possibility that plaintiffs could establish that defendants' conduct constituted fraud and thus denied defendants' motion to dismiss.5

Similarly, in Charter Services, Inc. v. DL Air, L.L.C., 711 F. Supp. 2d 1298, 1300 (S.D. Ala. 2010), three defendants, one of whom owned 100 percent interest in the lessee's company as well as significant shares of the other two defendant corporations, made most of the payments for the leased aircraft. Thus, the plaintiffs argued that the defendants should be liable for the lessee's breach of contract. In determining whether to pierce the corporate veil, the court analyzed the corporation's operations, but explained that the ultimate issue was whether the "plaintiffs presented substantial evidence of the existence of fraud or inequity in the use of the corporate form."6 The court also noted that the "fraud or injustice must be more than the breach of contract."7 Thus, the court refused to pierce the corporate veil and granted the defendants' motion for summary judgment because the plaintiffs' only evidence of fraudulent conduct related to the defendants' breach of contract.

Lease Obligations Following Bankruptcy

Airline bankruptcies continue to complicate the expectations of aircraft financiers. In Bremer Bank, National Ass'n v. John Hancock Life Insurance Co., No. Civ. 06-1534, 2009 WL 702009, at *1 (D. Minn. Mar. 13, 2009), aff'd, 601 F.3d 824 (8th Cir. 2010), the court upheld the foreclosure of the owner participant's equity share in a bankrupt airline as a result of a bankruptcy proceeding. The defendants gave instructions to the trustee to foreclose plaintiff's equity share, and the plaintiff claimed that the lease agreement required defendants to exercise remedies against the bankrupt airline prior to exercising remedies against the plaintiff. However, the defendants asserted that they had in fact exercised remedies against the airline prior to foreclosure of plaintiff's equity share. Accordingly, the case turned in part on whether the parties intended that there be a difference between language providing for "steps leading up to the exercise of a remedy" and the "exercise of a remedy." The court, relying on Lone Star Air Partners, L.L.C. v. Delta Air Lines, Inc., 387 B.R. 426 (S.D.N.Y. 2008),8 declined to recognize a distinction between "steps leading up to the exercise of a remedy" and the "exercise of a remedy." Thus, the court held that the defendants followed the appropriate procedures prior to foreclosing on the plaintiff's equity interest.

In an earlier case, In re Northwest Airlines Corp., 383 B.R. 575 (Bankr. S.D.N.Y. 2008), the court concluded that the lenders had not foreclosed on their security interest in the aircraft lease or its proceeds when they foreclosed on their security interest in the aircraft. Prior to bankruptcy, Northwest had entered into a leveraged lease of an aircraft. Penta Aviation was the beneficiary of an "owner trust" created to hold title to the aircraft and to lease the aircraft to Northwest. The lenders provided Northwest with most of the purchase price for the aircraft in exchange for a first priority security interest in the aircraft and the lease.

After Northwest rejected the lease and abandoned the aircraft, the lenders sent the trustee of the owner trust, Penta, and Northwest an Acceleration Notice defining collateral as the aircraft and the aircraft lease. However, when the Notice of Public Foreclosure Sale was published, it did not reference the lease or a claim for damages for breach of the lease. The court rejected the lenders' argument that the lease was conveyed as a matter of law with the aircraft, explaining that, at the time of foreclosure, the lease did not encumber the aircraft because Northwest had previously rejected the lease. The lease merely represented "a claim for damages against the lessee."9 Accordingly, the court held that the lenders had not "obtained all right, title, and interest of the Owner to a damages claim against [the airline],"10 and that the owner was the proper party to assert a damages claim for the airline's breach of the aircraft lease.11

Enforceability of Liquidated Damages Provisions

In yet another bankruptcy case involving Northwest Airlines, In re Northwest Airlines Corp., 393 B.R. 352 (Bankr. S.D.N.Y. 2008), the court, applying Minnesota law rather than the Uniform Commercial Code,12 concluded that the liquidated damages clauses in two aircraft leases were unreasonable and thus unenforceable. The court explained that the liquidated damages clauses were unreasonable because the calculation of damages was based on a static stipulated loss value ("SLV") that did not allow for depreciation of the aircraft over time and did not account for the lessee's payment of rent over the course of the lease. Moreover, the court indicated that SLV, a liquidated damages provision common in aircraft leases, would have been an appropriate template for the calculation of liquidated damages if the SLV declined over the course of the lease term. Other courts have also enforced liquidated damages provisions that account for depreciation and rental payments.13 Finally, addressing the lessor's argument that the court should consider the parties' sophistication when judging the reasonableness of the liquidated damages clause, the court noted that it is inappropriate to bind sophisticated parties to "patently unreasonable" liquidated damages provisions.

"Hell or Highwater" Clauses

As we have reported previously,14 a key factor in ensuring that any lease is financeable is whether the lease contains a "hell or high water" clause, requiring that rental payments will be made regardless of the condition of the aircraft. Historically, courts have uniformly recognized this type of provision and have consistently upheld its enforceability. Two recent court decisions, however, have been divided on that presumption.

In ACG Acquisition XX L.L.C. v. Olympic Airlines, S.A. [2010] EWHC 923 (Comm), a U.K. court refused to grant summary judgment to the lessor, ACG Acquisition XX L.L.C. ("ACG"), in a claim for unpaid rent by the lessee Olympic Airlines, S.A. ("Olympic"). Olympic stopped paying rent on a leased aircraft when it determined that, after the aircraft lost its Certificate of Airworthiness, repairs exceeded the value of the aircraft. Notwithstanding a fairly standard "as is-where is" disclaimer and a "hell or high water" clause in the applicable lease, the court refused ACG's summary judgment application and held that an aircraft suitable for immediate operation in commercial service had never been supplied.

In comparison, in Jet Acceptance Corp. v. Quest Mexicana, S.A. de C.V., No. 602789/08, 2010 WL 2651641, at *1 (N.Y. Sup. Ct. June 23, 2010), the New York court produced a more financier-friendly result. Jet Acceptance Corp. ("JAC") and Quest Mexicana, S.A. de C.V. ("Quest") entered into four aircraft operating lease agreements. Each lease agreement included a "hell or high water" clause requiring Quest to pay rent and perform all of its other obligations under the lease notwithstanding any defense or other circumstance.

After accepting the first aircraft for delivery and acknowledging in an Acceptance Certificate that the aircraft was delivered to Quest "as is-where is," Quest failed to remove the aircraft from its location and made only two payments on the aircraft. Subsequently, JAC tendered the remaining three aircraft pursuant to the terms of the lease, but Quest failed to comply with the delivery procedures or to make the required rental payments after it was deemed to have accepted delivery of the aircraft. While Quest sought to avoid the "hell or high water" clauses, the court recognized that "hell or high water" provisions are commonly respected and enforced in equipment leases. Moreover, the court precluded the airline from raising the doctrine of unconscionability to preclude enforcement of the clauses.

On appeal, the appellate court affirmed the lower court's decision in 201115 but noted that JAC ultimately did not need to rely on the "hell or high water" provisions. The court explained that while the "hell or high water" provisions required Quest to perform its obligations under the leases even if there was a legitimate reason not to perform, Quest had failed to establish that it had a legitimate reason for refusing to perform its obligations. Furthermore, the appellate court agreed that the doctrine of unconscionability rarely applies in a commercial setting.

Conclusion

Skilled counsel will want to study these recent court decisions and implement "lessons learned" when drafting new leases and advising clients regarding future disputes. Airlines and financiers must make every effort to define contract terms in aircraft leases consistently and unambiguously. Moreover, lessors must also remember that they cannot draft around debtors' statutory rights. Finally, recent cases also illustrate the importance of considering how a lessee's bankruptcy will affect the lease. Awareness of the recent trends in aircraft finance litigation will enable airlines and financiers to better protect their interests when drafting lease agreements and better defend against lawsuits involving the enforceability of lease provisions.

Footnotes

1. Our article focuses on cases addressing issues specific to aviation finance rather than cases addressing general principles of contract law.


2. Addison Express, 2006 WL 1489385, at *3. ADEX essentially argued that the lease should be construed as an installment contract.


3. Id. at *9.


4. Id. at *10.


5. NetJets Aviation, Inc. v. Peter Sleiman Development Group, L.L.C., No. 3:10-cv-483-J-32MCR, 2011 U.S. Dist. LEXIS 109973, at *1 (M.D. Fla. Sept. 27, 2011).


6. Charter Services, 711 F. Supp. 2d at 1309.


7. Id.


8. The Second Circuit Court of Appeals ultimately vacated the district court's opinion in Lone Star Air Partners, L.L.C. v. Delta Air Lines, Inc., noting that while both the bankruptcy court and the district court concluded that the relevant contract language was unambiguous, both courts disagreed about the meaning of the language. Thus, the court remanded the case to the bankruptcy court for an evidentiary hearing to determine the meaning of the contractual language at issue. In re Delta Air Lines, Inc., No. 08-2825-bk, 2009 WL 577588, at *3-4 (2d Cir. Mar. 5, 2009).


9. In re Northwest Airlines Corp., 383 B.R. at 583.


10. Id. at 582.


11. The court noted that the lenders' security interest in the aircraft lease was not eliminated when they foreclosed on the aircraft, and that the lenders "may have a lien on the proceeds of the Owner's Claim." Id. at 584.


12. Article 2A of the U.C.C. applies to any transaction that creates a lease, but the leases at issue in this case provided that Minnesota law governed all matters of construction, validity, and performance.


13. See Wells Fargo Bank Northwest, N.A. v. Taca Int'l Airlines, S.A., 315 F. Supp. 2d 347, 349-50 (S.D.N.Y. 2003).


14. See E. Evans and D. Reddy, "The 'Hell or Highwater Clause': A Closer Look at its Legal Enforceability by Courts in the United Kingdom and New York," Jones Day Airlines and Aviation Alert (Fall 2010). We repeat the discussion of these cases for completeness and because of their relevance to the area of aviation finance.


15. Jet Acceptance Corp. v. Quest Mexicana, S.A. de C.V., No. 5089, 602789/08, 2011 N.Y. App. Div. LEXIS 6272, at *1 (N.Y. App. Div. Sept. 1, 2011).

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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