The requirement for a mortgage

Banks and financial institutions require aircraft mortgages as a means of credit enhancement: to ensure as best they can that, in the event of the insolvency of the debtor, they will rank above its other creditors to the extent of the value of the aircraft.

However, because of the difficulties aircraft mortgages present in their creation and enforcement, aircraft transactions are often structured by way of a lease. Title to the aircraft is held by a single purpose company whose shares are charged in favour of the lender and who leases the aircraft to the airline. In this situation, where the airline lessee is in default, the lender may exercise its remedies under the lease (which will have been assigned to the lender) to recover the aircraft and remarket it to recover the outstanding debt. The security created by the aircraft mortgage may, in these circumstances, be considered as secondary or supplementary to the remedies available under a lease.

The terms of the Basel II Accord require banks to which it is subject and which have obtained the relevant approvals from their regulators to establish that they have “legally effective and enforceable security over the aircraft in every relevant jurisdiction” if they wish to use that security to reduce the risk weighting of any loan (and so the capital adequacy costs of making the loan available).

This requirement has resulted in an increased concentration by banks on how aircraft mortgages can be structured in a way which complies with the Basel II requirements, with less reliance being placed, for these purposes, on their rights under the assigned lease.

Back to top

What laws should govern the creation of an aircraft mortgage?

The Basel II requirement is that the banks obtain legally effective and enforceable security over the aircraft in every relevant jurisdiction. The problem is that different jurisdictions have different rules as to how aircraft mortgages should be created: some require that the mortgage be effective under the laws of the state where the aircraft is registered; others look to the laws of the place where the aircraft is physically situated at the time the mortgage is created (the lex situs). Still others will look to the laws of the place where the debtor is incorporated or of where the mortgage is executed and delivered.

In looking at these laws, it is also necessary to consider whether the applicable laws are the purely domestic laws of the relevant jurisdiction or if regard should also be had to their conflict of laws rules. For example: if English law says that a particular aircraft mortgage should be constituted in accordance with French law (because the aircraft is being delivered in France) but French law requires that mortgage to be effective under German law (because the aircraft is registered there), will an English court follow French conflict of laws rules and accept German law as well under a legal procedure known as renvoi or will it limit itself to considering the domestic law of France?

In any event, an aircraft mortgage that would be recognised by the laws of one jurisdiction may be ineffective under the laws of another.

Back to top

Mortgages under the laws of the state of registration

The aircraft mortgage which is most likely to be widely recognised is one which is governed by the laws of the state in which the aircraft is registered and which is executed and delivered at a time when the aircraft is physically situated in that jurisdiction. These are often referred to as “local law mortgages”.

However, lenders may be unwilling or unable to rely exclusively on local law mortgages:

• some jurisdictions (such as Austria and Thailand) do not have a concept of aircraft mortgages;
• other jurisdictions (such as Spain and Sweden) require a substantial duty to be paid on aircraft mortgages in order for them to be perfected, making them financially unattractive;
• other jurisdictions may only permit mortgages to be registered in favour of creditors who are nationals;
• still others require mortgages to be enforced through court procedures, which may be lengthy, unpredictable and financially inefficient; and
• lenders may have concerns as their ability to enforce their rights before some courts in the way they had anticipated.

Back to top

Mortgages under the laws of England or New York

When a lender is unwilling to rely on a local law mortgage, it may seek to obtain a mortgage which is governed by the laws of another jurisdiction, typically England or New York. These are often referred to as “foreign law mortgages”.

The laws of both England and New York are seen as being relatively creditor-friendly. They allow self-help (i.e. the right to enforce a mortgage without the need for court intervention). The courts, laws and procedures are well established and professional, and should not produce any unpleasant surprises. There are no taxes payable to create or perfect them and no restrictions as to who can be a mortgagee.

This briefing continues to discuss the circumstances in which an English or New York court would recognise a mortgage created under its own laws and what remedies those laws allow the creditors. However, it may well be that the mortgage will not be recognised in other jurisdictions, particularly the state of registration or, indeed, any other jurisdiction in which the aircraft happens to be at the time that the lender seeks to enforce its rights.

Therefore, even if the foreign law mortgage is properly constituted under its applicable law, lenders should not conclude that they will in practice invariably be able to exercise the rights it purports to give them. Neither should they assume that they will be able to avoid dealing with the governmental and judicial authorities of the state of registration by these means. If the lenders wish to remarket the aircraft, it will need to be deregistered and the aviation authority may have concerns as to how the repossession process has been conducted under mortgages which its domestic laws do not recognise.

Back to top

Creating an aircraft mortgage under English law

One of the exceptions to the general rule of English law that parties are free to choose whichever laws they wish to govern contracts is that the validity of a transfer of a tangible asset (which includes an aircraft mortgage) is governed by the law of the country where the asset is situated at the time of the transfer (lex situs). The question of how this rule applies to aircraft (which had been in some doubt) was addressed by the English High Court in the case of Blue Sky One Limited and others v Mahan Air and another [2010] EWHC 631 (Comm.) (Blue Sky).

There has been a great deal of commentary on Blue Sky: see, for example, our Briefing. To recapitulate briefly, the court held that:

1. aircraft should not be treated differently to other tangible assets: it is the lex situs of the aircraft which determines whether a property interest, such as a mortgage, is effectively created over it;
2. if the aircraft is registered in a different jurisdiction to the lex situs, a mortgage which is valid under the laws of the state of registration but which is invalid under the domestic laws of the lex situs jurisdiction will be ineffective in England; and
3. English law will look only to the domestic laws of the lex situs jurisdiction without reference to its conflict of laws rules in deciding the issue of validity of the mortgage: the court refused to apply the concept of renvoi described above.

The practical consequences of the decision are that, in order for an English law mortgage to be recognised by an English court, it must be effective under the laws of the jurisdiction where the aircraft is located at the time of its creation, without regard to the conflict of laws rules of that jurisdiction. Clearly, England will be a qualifying jurisdiction as may be a number of other jurisdictions which have adopted the same legal process required under English law for creating a mortgage.

The practice has therefore developed of requiring aircraft to be flown to a qualifying jurisdiction (or to its airspace) before it is mortgaged in favour of the lenders. The same procedure may be followed where the lenders wish to re-mortgage an aircraft because the Blue Sky decision has thrown doubt onto the validity of the existing security.

It is likely that an English court would also recognise an English law mortgage over an aircraft which is in international airspace but registered in a qualifying jurisdiction at the time that the mortgage is created.

Back to top

Creating an aircraft mortgage under New York law

In order for a New York court to recognize a New York law mortgage (called “security agreement” under New York law) over an aircraft the following minimum requirements need to be satisfied:

1. New York law should govern the security agreement. In most cases this would be determined by the parties selecting New York law as the governing law in the security agreement.
2. The New York court should have jurisdiction over a dispute arising under the security agreement. In most cases, this would be determined by the parties selecting the New York court as an agreed forum. No nexus to New York is required if (a) the agreement is governed by New York law, (b) the parties consented to the personal jurisdiction of the New York court and (c) an easily satisfied minimum threshold amount is met.
3. The security interest has “attached” to the collateral, that is, it has become enforceable against the debtor with respect to the collateral as described in the next bullet point. A security interest for this purpose is an interest in personal property which secures payment or performance of an obligation.
4. A security interest is enforceable against the debtor and third parties with respect to the collateral only if certain minimum requirements are satisfied, which in the case of an security interest over an aircraft would be that:
   1. value has been given;
   2. the debtor (the grantor of the security interest) has rights in the collateral or the power to transfer rights in the collateral to a secured party (here, the financing party); and
   3. the debtor has signed a security agreement (an agreement that creates or provides for a security interest) in the collateral;
5. The security interest has been perfected. In the case of a U.S. registered aircraft this requires filings at the U.S. Federal Aviation Administration and the Cape Town International Registry, as the U.S. is a Cape Town contracting state. In the case of a non U.S. registered aircraft, this requires either the filing of a Uniform Commercial Code Financing Statement in the relevant jurisdiction in the United States (most often the District of Columbia for most foreign debtors or foreign air carriers) or, in the case of foreign debtors whose home jurisdiction has laws that condition perfection on giving public notice in a filing, recording or registration system, filings in such jurisdiction.

The jurisdiction where the aircraft is located is immaterial to the enforceability of the New York law security agreement by the secured party against the debtor. On the other hand, if the aircraft is not located in New York, the New York court does not have “in rem” jurisdiction over the aircraft and local law procedures where the aircraft is located would apply with respect to repossession of the aircraft. Such procedures may not include self help, non judicial foreclosure and other remedies available under New York law. Consequently an aircraft will often be repossessed under local law procedures, if possible, and brought to the United States before a foreclosure sale is conducted.

If Cape Town is applicable to the security agreement, that is, either the grantor (debtor) is in a Cape Town jurisdiction or the aircraft is registered in a Cape Town jurisdiction, and other Cape Town threshold requirements are satisfied, Cape Town provisions may apply in lieu of certain of the provisions described above.

Back to top

Enforcing a mortgage before the English Courts

Should there be a default - typically non-performance of a payment obligation - it will be necessary to consider enforcement. A typical English law mortgage will have a comprehensive list of the powers of a mortgagee on an event of default. Most usefully it will have the power “to sell and give good title to the aircraft with or without prior notice to the Owner, and with or without the benefit of any lease or charter, by public auction or private contract at such place and upon such terms as the Mortgagee in its absolute discretion may determine”. There will also be a power to postpone any such sale and “without being answerable for any loss caused by such sale or resulting from that postponement”.

Enforcing a mortgage is often regarded as the mortgagee “stepping into the shoes of the operator”. They become for all intents and purposes the owner of the asset - they take possession of it and, most importantly, can sell and give good title to a third party purchaser.

In practice, there are various points to consider. Some jurisdictions, including England, allow a mortgagee to repossess a mortgaged aircraft and then to sell it privately or operate it or lease it out following the occurrence of an event of default under a mortgage without in each case first obtaining a court order. Such a right is sometimes referred to as “self-help”. If this is available it can materially reduce the cost of enforcement.

One potentially contentious area is that, if the mortgagee sells the aircraft following repossession, he should do so at the “best price reasonably obtainable”. In a volatile market, the best price reasonably obtainable may be a contentious issue: the concept has been tested before the courts on several occasions. Certainly a mortgagee should be meticulous in keeping records of its attempts to market and sell the aircraft, to document approaches made to it in that respect and, if necessary, obtain independent expert valuations as to the market value of the aircraft. We would always advise a mortgagee to ensure that the airline was aware generally of steps taken to sell the aircraft to avoid any possible challenge. However, the cases indicate, for example, that the mortgagee is not under a positive duty to wait until the market improves - the mortgagee should not be put in a position where it speculates on future volatility but can sell at the best price available at the time of sale.

If necessary, prompt judicial interim relief will normally be available to restrain the airline from removing the mortgaged aircraft from England. An urgent application for an injunction to detain the mortgaged aircraft and interim orders for the detention or delivery up of the aircraft may be obtained subject to the mortgagee giving an undertaking and/or security for damages against a wrongful claim.

Given English law’s familiarity with the concept of a mortgage, an English court will view a mortgage very much as it would a contract - that is, consider its terms and give full effect to the ordinary meaning of its provisions including the ability to take over possession of the secured asset.

Back to top

Enforcing a mortgage before the New York Courts

Following a default, a secured party’s principal remedies under a New York law security agreement, and some of the basic duties owed by the secured party to the debtor, include the following.

1. The secured party may sue the debtor for the amount owed and reduce its claim to a judgment against the debtor.
2. The secured party may take possession of the collateral, either through self help (if doing so would not result in a breach of peace) or judicial process. As noted above if the aircraft is not located in New York, self help and other New York law remedies may not be available under local law and a secured party will often want to repossess an aircraft under local law procedures and move it to a desirable location before proceeding with a disposition sale (further described below). As an example, aircraft are often repossessed and moved to an appropriate facility (such as those located in California or Nevada) where the aircraft can be stored and viewed by potential buyers before a disposition sale occurs. In connection with such repossession, a secured party will often de-register the aircraft from its current registry under local procedures and re-register it in the U.S. or another appropriate jurisdiction to facility a disposition sale.
3. The secured party may collect payments directly from account debtors, such as a lessee.
4. The secured party may sell or otherwise dispose of the collateral by public or private sale and apply the proceeds of the disposition towards the satisfaction of the secured debt. Every aspect of the disposition must be commercially reasonable. The secured party must send the debtor and other secured parties reasonable notification of the time and place of any public disposition or the time after which any private disposition is to take place. The secured party may purchase the collateral at a public disposition. A secured party disposition generally discharges all subordinate interests in the collateral and transfers title to the foreclosure purchaser.
5. The secured party may retain the collateral (i) in full or partial satisfaction of the debt if the debtor consents after notice or (ii) in full satisfaction of the debt if the debtor fails to respond to notice of the secured party’s intention to retain the collateral in satisfaction of the debt.
6. Upon disposition of the collateral, the secured party must account to the debtor for any surplus and the debtor is liable for a deficiency.
7. The debtor may redeem the collateral by paying off the secured debt at any time before the secured party has disposed of, or becomes contractually committed to dispose of, the collateral or has retained the collateral in satisfaction of the secured debt.

As noted above, if the Cape Town Convention applies, Cape Town provisions may apply in lieu of certain of the rights and remedies described above.

Back to top

The Cape Town Convention

Different considerations apply to aircraft subject to the Cape Town Convention. The Official Commentary on the Convention written by Professor Roy Goode acknowledges that “traditional conflict of law principles [are] unsuited to items of mobile equipment which are consistently moving from one country to another”. The Convention, by its terms, provides for how a security can be created over an aircraft and does not require it to be effective under any pre-existing domestic law: such security, created under a document often referred to as a “Cape Town Security Agreement”, should be effective if it is compliant with the conditions of the Convention, notwithstanding that a formality required by any domestic law for the creation of a mortgage was absent. For example, if the United Kingdom ratifies the Convention, a valid Cape Town Security Agreement over a relevant aircraft physically situated in Toulouse would create effective security under English law even though the lex situs, France, would not recognise it.

For the Convention to be relevant for the purposes of creating security over an aircraft either (i) the debtor must be located in Contracting State to the Convention or (ii) the aircraft must be registered in a Contracting State. If the second condition is met, but not the first, the security may only be effective in respect of the airframe (and not its engines).

For example: a lender finances the acquisition of an aircraft by a company incorporated in Ireland (which has ratified the Convention) for lease to an airline in France (which has not). The aircraft is registered in France. The Irish company enters into a valid Cape Town Security Agreement: that should create effective security before an Irish court though it would not be recognised in France.

The lender will then have to carry out an analysis as to whether the Cape Town Security Agreement, when taken with the rest of the security package given to it by the borrower and its parent, is sufficient to satisfy the requirement that it has legally effective and enforceable security in every relevant jurisdiction (including, in the example given, Ireland and France).

Back to top

Practical recommendations

A lender wishing to obtain legally effective and enforceable security over an aircraft has five choices. They need not be mutually exclusive. The options, with their advantages and disadvantages, are outlined below.

Take security over the aircraft under the laws of the state of registration, preferably when the aircraft is physically situated in that jurisdiction

The advantage of this approach is that the mortgage should be recognised in jurisdictions that look either to the laws of the state of registration of the aircraft as well as those of its lex situs. In particular it will almost certainly be recognised in the state of registration itself, where some enforcement action will in any event be required.

However it may be legally impossible, or too expensive, to take such a mortgage for the reasons described above. The lender may not be satisfied with the remedies that that mortgage provides or there might be uncertainty about the outcome of enforcement action in that jurisdiction.

Take security under the Cape Town Convention

Where possible, security should be taken under the Cape Town Convention. The procedures for doing so are clear, as are the remedies available to the creditor (which will depend on the declarations made by the relevant Contracting State on ratification).

However, this form of security may not be available in certain cases: as discussed, the borrower needs to be located in a Contracting State. If it is not, but the aircraft is registered in a Contracting State, the lender may be able to obtain security over the airframe only, leaving a gap in the asset security.

Even if the borrower is in a Contracting State, it does not follow that this security will be effective and enforceable in every relevant jurisdiction. If, for example, the Borrower is located in Ireland, but the airline in France, and the aircraft registered in France, a French court would not recognise this security.

Rely on the ownership of the aircraft by the borrower single purpose company over whose shares it has security

In many financings, the borrower will be an orphan trust single purpose company whose shares are charged by its parent in favour of the lender. The lease from the borrower to the airline lessee will be assigned by the borrower to the lender so, under English law, if the lessee defaults, it is the lender who has the right to terminate the lease period and repossess the aircraft. The lender can remarket the aircraft and instruct the borrower to enter into a sale agreement providing for the proceeds to be paid directly to the lenders. If, for any reason, the borrower refuses to co-operate, the lender can enforce the share security.

The borrower may have a constitution which restricts the business which it is entitled to conduct and will also agree to contractual restrictions on its activities: it should have no other creditors if it is properly managed and it conducts itself in accordance with all relevant loan covenants and its constitutional documents. Any debts of the borrower other than the loan (for example to third parties or tax authorities) should be the subject of indemnities under the lease. Accordingly, the borrower should not have any other creditors to rank in competition with the lender, so obviating the need for a mortgage at all.

However, absent a mortgage, the lender will be taking performance risk on the borrower and its parent, and on the compliance by the lessee with its indemnity obligations under the lease. In addition, banks would need to consider the effect of the absence of a mortgage on the treatment of the transaction for Basel II purposes.

Take security over the aircraft under English law

For an English law mortgage over an aircraft to be recognised as being effective by an English court, the aircraft will need to be in England, or another qualifying jurisdiction, at the time that the security is created. By a “qualifying jurisdiction”, we mean one whose domestic laws will recognise an English law mortgage as an effective way of creating security. Advice needs to be taken on a case by case basis as to whether any particular jurisdiction qualifies. To achieve this result, it is necessary either to require the aircraft to fly to relevant airspace following delivery or to wait until the aircraft actually arrives there in the normal course of its operations, before the mortgage is created.

A slight refinement of this principle is that, if the aircraft is registered in a qualifying jurisdiction, the mortgage may be created whilst it is in international airspace.

It should be noted that this mortgage may not be recognised in every relevant jurisdiction. It should be recognised in the qualifying jurisdictions but these may not include the state of registration. Lenders also need to recognise that they will not be able to avoid dealing with government and judicial authorities there completely by selecting a foreign law mortgage: in particular they will need to procure the deregistration of the aircraft, which may be difficult if the legality of their repossession is being contested.

Take security over the aircraft under New York law

It is relatively easy to take an aircraft mortgage under New York law that will be recognised by the courts of New York, but, absent any relevant nexus with the state of registration or with the lex situs, lenders need to be aware that it may be difficult to enforce that security in other relevant jurisdictions. As with English law mortgages, lenders also need to recognise that they will not be able to avoid dealing with government and judicial authorities in the state of registration completely by selecting a foreign law mortgage.

Conclusion

Lenders still have a variety of options to take security for aircraft finance loans. Which security package suits which loan will depend on an assessment of the facts and circumstances of each case. Our recommendation would be for lenders to seek early legal advice (preferably at term sheet stage) to ensure that lenders optimise their security package to achieve their commercial objectives and minimise legal, regulatory and jurisdictional risk.

Back to top