Research Trends and Conclusions: Aviation 2010

• February 2010

• Aviation

Richard Noakes

The global recession has caused a considerable shift in the aviation industry. Previous recessions in 1991 and 2001 have made the aviation sector resilient but it has not been able to avoid substantial losses as a result of the more recent downturn.

Nevertheless, a number of transactions have continued despite the predicted slowdown, and so lawyers are still busy. This activity is largely a result of the increase in credit backed by export credit agencies (ECAs), continued, if somewhat diminished, investments from capital markets and relatively low oil prices. This has ensured that despite the recession the industry has performed better than expected.

MARKET DEVELOPMENTS

The International Air Transport Association (IATA) has reported that compared with 2007 when the industry reported a $12.9 billion net profit, global commercial airlines lost $16.8 billion in 2008 and $11 billion in 2009 and a loss of $5.6 billion in 2010 is forecasted, a pattern that suggests that at least the worst may be over. Global passenger traffic is estimated to have contracted by 4 per cent in 2009 and is not expected to rise to anywhere near pre-recession levels until 2012. Such a difficult economic climate resulted in a range of bankruptcies being filed in 2008 by airlines such as Aloha Airlines and Skybus Airlines in the US, Silverjet in the UK as well as XL, one of the country’s largest tour operators that left 85,000 passengers stranded in airports around the globe. By September 2009 a total of 670 aircraft were reported to be up for sale, a 50 per cent increase on December 2008. However last year did not see nearly as many bankruptcies.

Lawyers that we spoke to have noted a major contraction in the market as commercial lending has fallen significantly in the face of the global recession. The number of banks with a significant role in aviation finance has continued to dwindle, although stalwart financers such as RBS and Barclays have remained in the sector. While banks have been taking a conservative approach to the aviation industry, commercial lending has not dried up completely. Lawyers note that money is available for the right clients. There is now a new focus on the relations between banks and airlines to ensure there is a long term strategic purpose behind them. In addition, the lack of available credit has meant that some airlines are looking to sublease their grounded aircraft and this has driven more work for lawyers who are experts in that area.

Commercial banks have been acting agonisingly slowly in approving credit, and some lawyers stated that credit decisions are taking up to four times as long. One of our sources reported that in one transaction a bank provided credit to an airline just one hour before the delivery of aircraft. This slowness is due to a number of reasons. Transactions are now subject to increased scrutiny, and many banks now have credit and liquidity committees that significantly slow down the appeal process. There have also been lay-offs of staff with expertise in the aviation industry who were able to make more immediate decisions concerning the approval of credit. Ongoing credit deals are being reassessed whenever the banks set new lending criteria and jurisdictional risk is increasingly being taken into account. While this sluggishness has come as an added frustration for finance lawyers, the increased scrutiny of transactions can arguably be seen more widely as a positive development that will help the industry avoid the potentially disastrous consequences of almost unrestricted access to credit.

Manufacturers are also struggling in current market conditions. Boeing reported a $1.6 billion loss in the third quarter of 2009 as it encountered costly delays in two of its airplane programmes including the 787 Dreamliner passenger jet, which has been held up for two years due to design and production problems. Airbus also reported third quarter losses in 2009 of $130m as a result a fall in the value of aircraft.

Aircraft leasing companies have also experienced an increasingly tough market following a fall in demand. This has led to a reduction in the value of aircraft by as much as 10 per cent as prices hit rock bottom in July-August 2009. Many airlines have proven unable to pay for their scheduled delivery of aircraft and leasing companies are being pushed by the banks to pay back debt and this has increased the pressure on aircraft lessors to default. All this has led to an increase in leasing disputes.

Two of the largest leasing portfolios are up for sale, namely AIG’s International Lease Finance Corporation, which owns 1,046 aircraft valued at $52 billion; and RBS Aviation Capital, which owns 226 aircraft valued at $8 billion. CIT is also expected to sell off its aircraft leasing unit, valued at $8.6 billion. But the largest leasing portfolios are up for sale because of the wider financial concerns encountered by their owners rather than the unprofitability of the leasing market. Indeed, new joint ventures have emerged such as GreenStone Aviation, which was launched by the co-founder of RBS Aviation Capital, and KV Aviation initiated by former Allco CEO David Veal and founder John Kinghorn in March 2009. This should be taken as a clear indication that aircraft leasing retains the potential to be a profitable and active market.

As credit has become harder to obtain, lawyers have been dealing increasingly with ECAs to fill the projected $30 billion gap in funding. So far it is estimated that ECAs have financed $20 billion worth of Airbus and Boeing aircraft and this has ensured that lawyers who have strong relations with the ECAs have not experienced a continued reduction in activity. While many banks such as ING and WestLB left the market, others have been quick to step in and provide credit backed up by ECAs and banks such as Calyon, which has provided $9.2 billion in export credit finance, have benefited.

The German KG market, which has only recently turned its attention to aircraft financing, was predicted to slow down due to a lack of available debt and equity. 2009 was a hard year for German KG companies in general as local finance specialist Deutsche Zweitmarkt reported that 108 KG houses are facing the possibility of insolvency. This has made it more difficult to attract investors who are looking for secure investments and has meant that the leading KG arrangers are also focusing on safe deals typically at the high end such as the financing of three A380s arranged by Doric Asset Finance in 2009 that is expected to close in 2010. Nevertheless, in the first half of 2009 alone there were already 10 closed KG funds in total worth over $1.6 billion that had financed three 777-200 LRFs, two 777-300ERs, an A340-600, three A319s and an A320. This compares favourably with total KG funding worth $1.8 billion in 2008 as a whole.

The aviation industry has benefited from low oil prices in 2009. In May oil prices were around $60 a barrel and rose to over $80 a barrel at the end of October. However, towards the end of the year oil prices had fallen again to around $72 a barrel as Chinese demand for crude oil fell. The opinion among most of the lawyers we spoke to was that oil prices will rise in 2010 and if they do, we may see more bankruptcies in the industry.

Renegotiating and rescheduling of deals have proved popular. A distinctive feature of the downturn is that the potential to default exists on both sides, not only for the airlines, leasing companies and manufacturers but also for the banks. Consequently banks have been going back to their clients stating that they cannot fund agreements. The lack of credit and demand has meant that lawyers have had to create innovative ways of deferring deliveries for airlines. In November 2009 US Airways deferred the delivery of 54 of the 72 aircraft to be provided by Airbus in 2010-2012.

The credit provided by ECAs and the continued activity of German KG leasing has ensured that aviation finance has not come to a complete standstill as was predicted. 2009 was surprising because in contrast to expectations of continued airline bankruptcies, money is still available for the right clients and investment is being provided for the right transactions that ensure an appropriate return.

REGULATION

Regulatory lawyers are renowned for their cross-border proficiency and such expertise has been and will be increasingly important in the coming years. In terms of European regulation, in June 2008 the adoption of the Single European Sky II (SES II) programme meant that the European Aviation Safety Agency’s remit was extended to the regulation of aerodromes, air traffic management and air navigation services in an effort by the EU to harmonise the regulation of its airspace. Such developments arising from the SES programme will undoubtedly create new areas of work for lawyers involved in European regulation. There have also been significant developments concerning air passenger rights in the EU that John Balfour at Clyde & Co LLP elaborates on in his article beginning on page 14 of this book.

In 2008 the global aviation sector emitted 670 million tons of carbon dioxide. The discussions that took place in Copenhagen in the autumn of 2009 have shown that any global agreement concerning cuts in emissions involves an incremental diplomatic process. Once an agreement has been made, there is no doubt that the aviation industry will face regulatory measures concerning its total output of CO2.

The EU’s Emissions Trading Scheme is set to commence in 2012 and it has been estimated that the industry will need to spend as much as $52 billion between 2012 and 2020 on carbon permits. This has the potential to be a significant burden on the industry. However, it is unlikely that this will prove to be an active area for lawyers – some sources indicated that clients are already very knowledgeable in regard to this legislation and that this work will be done in-house by airlines.

One of our sources also notes that the European Commission is becoming more realistic, with a focus on detailed economic modelling. Instead of looking primarily at market share, the commission is also analysing the ability of a company to raise its prices. As a result lawyers increasingly require the expertise provided by economists when such economic modelling is used.

TRANSACTIONS

The most significant recent development concerning competition litigation has been the ruling of the UK Competition Commission that the British Airports Authority (BAA) must shed its dominance in the UK and sell three of its airports. Gatwick Airport was sold to Global Infrastructure Partners (GIP) for £1.5 billion making it one of the biggest infrastructure deals of the year. Stansted and Glasgow Airport are expected to be next in line. At the time of writing BAA had challenged the ruling in the Competition Appeals Tribunal and won part of the appeal on the basis that one member on the panel of the Competition Commission had a conflict of interest in taking part in the decision. In any industry where it becomes increasingly likely that companies may default, consolidation becomes a common feature. However, even the aviation industry with its global reach has been unable to transcend national boundaries whereby air services require the permission of the government in question to operate in its airspace. Jean Paul Poitras at Latham & Watkins candidly stated that “until you can take broader innovative steps in making regulation more normal and allowing cross-border mergers we are not going to have the consolidation that the industry needs”. This is certainly an important issue given the financial predicament that the industry finds itself in.

Increased consolidation and alliances between airlines could ensure that they stay afloat. In November 2009 IATA announced the signing of the Multilateral Statement of Policy Principles regarding the implementation of bilateral air service agreements by Chile, Malaysia, Panama, Singapore, Switzerland, the United Arab Emirates and the United Sttaes, which was endorsed by the European Commission and will apply to around 60 per cent of global civil aviation. This was considered a historic achievement in liberalising the industry but, as Giovanni Bisignani, the director general and CEO of the IATA, has stated, now the challenge is for governments to apply the policy principles they agreed to and bring more states on board. Once the industry finally manages to transcend restrictive national boundaries it will then be capable of much-needed cross-border consolidation, no doubt creating a considerable volume of regulatory and merger work for aviation lawyers.

HUBS OF ACTIVITY

The Cape Town Convention on International Interests on Mobile Equipment, which came into force a few years ago has effectively reduced the risk of lending for aircraft financiers and therefore cut the cost of borrowing. This has helped to make funding more available and regions such as the Middle East have certainly benefited.

The aviation industry in the Middle East has performed better than most regions during the economic crisis. The IATA stated that European airlines will generate the largest losses of $2.5 billion in 2010 compared with just $300 million in the Middle East, an improvement from $1.2 billion in 2009. The recent Dubai crisis created doubts regarding the economic stability of this region and particularly in regard to Emirates Airlines which is owned by the Dubai government and has $55 billion of aircraft on order. However, despite the potential problems it may face the president of Emirates, Tim Clark, has stated the airline will continue to grow.

While the region has experienced a contraction in credit availability it has been able to source its investment from outside the region and through ECAs. In 2009 Etihad Airways ordered more than 250 engines estimated to be worth around $7 billion. Qatar Airways ordered 20 airbus A320s and four A321s costing $1.9 billion and has increased flights to Paris, Turkey, Melbourne, Sydney, Amritsar and Goa while low-cost airline Flydubai has added its fifth route. Aircraft leasing in the region is also experiencing strong activity as DAE Capital secured a $450m loan from Citibank to purchase nine Boeing aircraft. Some South-East Asian and European airlines appear interested in launching flights out of Abu Dhabi.

After a government-led stimulus package to finance aircraft deliveries, Chinese airlines have been looking to domestic institutions rather than foreign banks, which has bolstered activity and investment in China and the wider region. The China Development Bank (CDB) closed its first loan for an international aircraft lessor, AerCap, in November 2009 worth $358 million financing four A330s. CDB Leasing Company which is owned by CDB purchased 12 aircraft with leases attached from Gecas worth around $700 million. Australia’s Foreign Investment Board approved the acquisition of Allco by HNA group and ICBC Leasing agreed a letter of intent with Sichuan Airlines for six sale/leaseback deals for the A320.

The only region that has been able to defy the global recession is Latin America, which has experienced profits of $100 million in 2009 with the same projected in 2010. The region was previously perceived by investors to be risky. This is less the case now and Latin America’s airlines are now increasingly attracting investment.

LOOKING TO THE FUTURE

The aviation industry is certainly resilient and has outperformed – admittedly low – expectations. Despite such huge losses and the deep recession the aviation sector has experienced, transactions and investments have continued and lawyers are still busy. This has been largely a result of the credit backed up by ECAs, relatively low oil prices and more selective investments provided by capital markets. The performance of the industry in 2010 and the coming years will depend primarily on these factors. Among the lawyers who contributed to our research, opinion was much divided on the future of the industry; some argued that the real problems will not be felt until later this year while others believe that the industry will get back on its feet in 2010. Nevertheless, what is certain is that in such a climate lawyers will have to be especially sensitive to the changing dynamics of the industry and the needs of their clients.

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