Article ABA - The Air & Space Lawyer

Restructuring Aircraft Fleets Under Section 1110 of the Bankruptcy Code: Selected Issues

This article focuses on one aspect of airline bankruptcies, the restructuring of aircraft debt, describes challenges facing air carriers, and reviews current and developing issues in this area.

One of the defining characteristics of the airline industry is that service to customers can be provided only by using extremely expensive, technologically complex, high-maintenance mobile equipment: aircraft. An airline’s need for these assets creates dynamics that shape and color the industry’s economic, political, and legal climate.

Airlines typically have used a wide variety of financing arrangements, including secured loans, sale/leasebacks, operating leases, pass-through certificates, and leveraged leases. Recently, airlines have begun using more complex and sophisticated structured financing transactions, such as the issuance of equipment trust certificates and “enhanced” equipment trust certificates (EETCs). Although the older methods of financing aircraft were usually private transactions, these new financings involve the issuance of public securities.[1]

The financing counter parties to these transactions -- aircraft financiers -- early on realized that they would be more fully protected if they were granted special dispensation by Congress in the event their borrowers filed bankruptcy. What they sought, and ultimately achieved, was exceptional status as creditors in a bankruptcy, allowing them to repossess collateral in the event of a default while most other creditors were prevented from doing so. [2] This special status is embodied in Section 1110 of the Bankruptcy Code (Code). [3] Because the special protection afforded aircraft financiers by this section is in derogation of one of the Code’s underlying premises, e.g., equality of treatment for creditors, litigious sparring between airline debtors and aircraft financiers has at times produced judicial opinions that have narrowed the section’s application. Section 1110 was therefore the subject of ongoing political maneuvering, and financiers persuaded Congress to amend the section in 1978, 1994, and 2000 to counteract these decisions. [4]

However, the creditor-friendly provisions of Section 1110 have also benefited airlines. Because airline financiers have greater comfort that they can repossess even in bankruptcy, their aircraft financing activities are less risky and provide airlines with access to reasonably priced capital. For example, commentators have noted that bond-rating organizations historically have given senior tranches in EETCs investment-grade ratings, often higher than the airline’s other secured debt, yet at the same time given airlines the benefit of lower interest rates. [5]

Debtor Choices Under Section 1110

Generally, once a debtor files for bankruptcy, the Code’s automatic stay prevents a secured creditor from repossessing its collateral as long as the collateral is “adequately protected.” [6] Thus, if the secured creditor is either over- or under-collateralized but the debtor has provided adequate protection in the form of payments or another mode, the secured creditor has no grounds to persuade the bankruptcy court to lift the stay to repossess its collateral. [7] The stay allows the debtor to keep its assets while it reorganizes and was designed to carry out the Code’s policy of avoiding the disorderly, piece-meal dismemberment of the debtor’s estate by its creditors.

To continue the automatic stay’s protection of aircraft equipment, Section 1110 requires the debtor-in-possession (DIP) to “agree to perform all obligations of the debtor” under the financing agreement and cure all pre- and post-petition defaults by the 60th day after the bankruptcy filing (an 1110(a) Election). In the absence of a consensual extension of this 60-day period, the DIP’s failure to “assure and cure” voids the automatic stay and allows the aircraft financier to exercise its contractual remedies against the aircraft, which usually give it the right to repossess. Courts have held that the financier’s Section 1110 rights to immediate surrender and return of the aircraft cannot be trumped by other provisions of the Code (i.e., impairing the financier’s rights through a plan of reorganization under Section 1129).

An 1110(a) Election keeps the automatic stay in place but does not constitute a reaffirmation of the underlying financing agreement. However, a Section 1110(a) Election requires immediate monetary cure and may create substantial administrative liability going forward, for courts have held that current obligations under the financing agreement are to be treated as administrative expenses. Complex 1110(a) Election decisions may be very challenging for an airline to make within 60 days, the more so the larger the carrier’s fleet. This is akin to forcing a national retailer to decide which of its store locations to keep open and which to close within 60 days of filing and before formulating its business plan.

As an alternative to an 1110(a) Election, the DIP may enter into a consensual extension of the 60-day period under Section 1110(b)(an 1110 Stipulation). Because of the leverage the financier gains as a result of the DIP’s short 60-day window, such extensions may not necessarily be at a discount to the contractual rate. Which party actually gains the leverage, however, heavily depends on the current state of the aircraft market. Therefore, an 1110(b) Stipulation buys some stability for the DIP, but possibly at a price.

Failure of the DIP either to make 1110(a) Elections or enter into 1110(b) Stipulations leaves the DIP’s aircraft “naked.” On first blush, going naked poses obvious risks to the airline’s ability to operate -- the threat of seizure by the financier at any time, for example -- and creates potentially huge customer service, public relations, and operational issues. It seems all the financier must do is “make a written demand” for possession to the DIP pursuant to Section 1110(c)(1), and the DIP “shall immediately surrender and return” the aircraft.

Market Undercutting

The benefits of Section 1110, which include contract performance and quick repossession of the aircraft, however, can be significantly undercut by the marketplace. If the airline’s bankruptcy is attributable chiefly to macroeconomic, exogenous factors that deflated the value of most aircraft, the financier’s repossession rights may not be all that attractive. In 2004, more than 3,000 narrow-body and wide-body aircraft were stored in the desert -- a result of fleet downsizing, switching routes to regional jets, and other fleet restructuring steps by air carriers. [8] Seizure and repossession without having a secondary buyer for an aircraft asset forces the financier to absorb carrying costs for an indefinite period. In a situation like this, many financiers have taken the view that restructuring the airline, not repossession, presents the best source of recovery.

Additional Questions

A sampling of as yet clearly unanswered questions provides a sense of still other issues facing the industry.

What is the meaning of “surrender and return” when the airframe’s engines have been swapped out?

A demand to surrender and return a B-747 whose original engines are now on four other airframes may require grounding and reconfiguring of up to five aircraft. The bankruptcy court in the US Airways case noted (but did not rule upon) the debtor’s concern that it might be “required to shoulder, as an administrative expense, the costs of actually returning the aircraft (which might, for example, include the cost of reinstalling original engines where those engines had been removed for repair or overhaul).” [9]

Courts have recognized that it is common for aircraft leases and security agreements to allow the operator to exchange engines and other parts through pooling or interchange agreements. The Pan Am court held that simply because the exact equipment may not remain the same does not remove the financing agreement from the purview of Section 1110, reasoning that the lessor would still be entitled to the return of specific, identifiable property. [10]

Does “surrender and return” mean “deliver the aircraft” or “let the financier pick it up?”

Leases commonly include a provision dealing with this issue. For example, when a lessor attempted to repossess two Pan Am aircraft, the court ordered the debtor to ground the planes in two different locations, pursuant to the terms of the lease. In its brief appealing that decision, Pan Am argued that Section 1110 did not require the debtor to deliver the aircraft to the financier, only to furnish the financier with information about the aircraft’s location. The court did not rule directly on this argument but noted that Pan Am did not dispute that it was bound by the terms of the lease.[11]

Can pre-petition payments to the financier be recovered as preferences?

Section 547(b) of the Code allows a debtor to recover certain payments made to a creditor within 90 days of bankruptcy, a provision made to promote equality of distribution among creditors. Section 547(b)(5) requires a debtor to establish that the payment in question resulted in the creditor’s receiving more than it would receive had the transfer not taken place and the creditor received a distribution under a liquidation of the debtor’s assets (i.e., more than its “fair share”). Courts have held that, when the debtor makes an 1110(a) Election and makes cure payments, the debtor would be required to pay the preferential payments if the monies have not already been made. Thus, the creditor does not really improve its position, and the pre-petition payments are not preferential and cannot be set aside. Courts have noted that allowing a debtor to challenge these payments as preferences would be the equivalent of “thwart[ing] the effect of [Section 1110]. [12]

Must the financier perfect its lien to enjoy Section 1110 protection?

In short, yes: Creditors usually must have perfected their security interests to be treated as secured creditors in a bankruptcy case. Yet courts have held that a financier can enjoy the protection of Section 1110, including repossession of aircraft collateral, even if its security interest was not properly perfected -- by recording with the FAA registry or filing a Uniform Commercial Code financing statement. The rationale for this is that Congress made it clear that a financier’s Section 1110 rights are “not limited or otherwise affected by any other provision of [the Bankruptcy Code] or by any power of the court.[13] Thus, a debtor could not use its strong-arm powers under Section 544 of the Code to set aside a financier’s rights. Courts have observed that Section 1110 itself did not specifically require a financier to perfect a security interest and that the statute is “unambiguous in allowing a creditor to repossess once the elements of §1110 were satisfied.” [14]

Is a breach of the aircraft’s return on conditions an administrative expense of the estate?

Let us suppose that a carrier operates an aircraft after filing a bankruptcy petition, runs that equipment down to zero cycles (a measurement of operating time left in equipment before maintenance) and then rejects the lease and returns the aircraft.[15] A Delaware court that considered this question used as the basis for its analysis Section 503(b)(1) of the Code, which provides that only the “actual and necessary expenses of preserving the estate” should be entitled to administrative expense status. The court decided that because neither removing the airline’s logo nor repairing an engine would confer any benefit to the debtor’s estate, that claim was not an administrative expense.[16] Another court, noting that the airline debtor made an 1110(a) Election to reject the aircraft but then kept the aircraft for a period of time, held that the 1110(a) Election obligated the airline to fulfill its obligations under the lease as they came due, and that required maintenance between the aircraft’s rejection and return constituted administrative expenses.[17] If the aircraft had been returned immediately upon rejection, however, would the result have been the same? Because of the unsettled state of the law regarding breach of return conditions, one commentator suggested that lessors look to commercial rather than legal solutions; these include expanded maintenance reserves, security deposits, or letters of credit in the case of noncompliance with return conditions.[18]

Conclusion

The story in this area of the law is still being written. The balance of power between airline financiers and airline debtors will continue in flux. New debt structures will be developed, and jurists and attorneys will continue to struggle to stretch the Bankruptcy Code to fit the needs of the industry. The key battles in this area may not be fought in courtrooms, but the winners might well be determined in Washington, as Congress continues to seek ways to encourage investment in aircraft and provide affordable credit for the airline industry.

Notes

1. See, e.g., Ronald Scheinberg, Enhanced Equipment Trust Certificates in the Downturn: An Assessment for Banks, 121 BANKING L.J. 108 (2003); William J. Murphy, Proposal for a Centralized and Integrated Registry for Security Interests in Intellectual Property, Appendix 5, 41 IDEA 429, 441 (2002); Jason J. Kilborn, Thou Canst Not Fly High With Borrowed Wings: Airline Finance and Bankruptcy Code § 1110, 8 GEO. MASON L. REV. 41, 63-65 (1999). 

2. For a discussion of legislation as a competitive strategy, see G. Richard Shell, MAKE THE RULES OR YOUR RIVALS WILL, ch. 2 (2004).

3. 11 U.S.C. § 1110.

4. For a detailed history of § 1110, see COLLIER ON BANKRUPTCY ¶ 1110 L.H. (15th rev. ed. 2003); Gregory P. Ripple, Special Protection in the Air[line Industry], 78 NOTRE DAME L. REV. 281 (2002).

5. See e.g., Kilborn, Thou Canst Not Fly High With Borrowed Wings, supra note 1.

6. See 11 U.S.C. § 362 (automatic stay), § 361 (adequate protection).

7. BANKRUPTCY CODE § 362(d) provides for requests to lift or modify the automatic stay.

8. Ian Goold, Air transport ills may be overstated, AVIATION INT’L NEWS, July 19-21, 2004.

9. In re US Airways Groups, Inc. 287 B.R. 643, 646 (Bankr. E.D. Va. 2002).

10. In re Pan American Corp., 929 F.2d 109 (2d Cir. 1991). See First Sec. Bank of Utah, N.A. v. Northwest Airlines, Inc., 43 F.Supp.2d 136 (D. Mass. 1999) (discussing whether aircraft operator entitled to return aircraft with parts less valuable than originals.)

11. See Evergreen Int’l Airlines, Inc. v. Pan Am. World Airways, Inc., 1993 WL 13105686 *11 (9th Cir. 1993) (appellate brief); unpublished appellate opinion available at 46 F.3d 1140 (9th Cir. 1995).

12. In re Kiwi Int’l Air Lines, Inc., 344 F.3d 311, 321 (3d Cir. 2003). See also Seidle v. GATX Leasing Corp., 45 B.R. 327 (S.D. Fla. Nov 14, 1984), order aff’d, 778 F.2d 659 (11th Cir. 1985).

13. 11. U.S.C. § 1110(A)(1). See, e.g., In re Vanguard Airlines, Inc., 302 B.R. 292, 299 (Bankr. W.D. Mo. 2003).

14. In re Air Vermont, Inc., 761 F.2d 130, 130-31 (2d Cir. 1985); see also In re Vanguard Airlines, Inc. 295 B.R. 908, 914-20 (Bankr. W.D. Mo. 2003).

15. See In re Continental Airlines, Inc., 146 B.R. 520, 528 (Bankr. D. Del. 1992).

16. In the Matter of Continental Airlines, Inc., 146 B.R. 520 (Bankr. D. Del. 1992).

17. In re Trans World Airlines, 145 F.3d 124, 130,(3d Cir. 1998).

18. John I. Karesh, Issues Affecting Administrative Claim Status and Other Remedies for Aircraft Lessors in Airline Bankruptcies, 6 J. Bankr. L. & Prac. 429, 441 at n. 47 (May/June 1997).

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