Leasing an Aircraft
An aircraft lease is a common practice in the airline industry. Aircraft is of high value. This being a primary reason, airlines tend to lease in an aircraft. An outright purchase has various implications. Mainly of financial kind.
Airlines avail crucial advantages by operating a leased aircraft. These advantages may include, inter alia, capital expenditure savings otherwise needed for aircraft purchase, trimming fleet through lease termination or sublease and, in the case of a wet lease, also capital expenditure savings on crew hiring, training and retention. Leasing enables an airline with agility to swing through fleet enhancement and fleet trimming. Thus an airline can alter fleet size in response to a change in market demand and environmental vulnerabilities.
In order to comprehend an aircraft lease, one should stand on a vantage point. From here, one can view different dimensions of the subject.
A lease is a contract, an agreement enforceable by law. A lease contract has two or more parties. Besides these parties, there may be other beneficiaries, namely, financers, owner/s (if the lessor and the owner are different), and so on. A lease contract assures beneficiaries of their rightful claims in the agreed hull value in case of a loss during the lease. Such an assurance is a condition precedent in a lease contract. Aviation insurance policy incorporates this matter.
The safe operation of aircraft is a primary concern of all airlines. Regulators hold airlines accountable for flight safety. All stakeholders are also generally concerned with this matter. The safe operation of the aircraft and maintenance of its continued airworthiness are essentially ingrained in a lease contract. Rights and responsibilities for these functions are delineated in the contract. In the case of a dry lease, such rights and responsibilities transcend to the lessee-operator. In the case of a wet or damp lease, they generally befall the lessor-operator. A dry lease empowers the lessee with the operational control right. This right endows the lessee with the power for originating, conducting and terminating a flight of the leased aircraft.
An aircraft lease requires defining safety oversight responsibilities. The oversight is of the operation and continued airworthiness of the aircraft. By Chicago Convention, safety oversight responsibilities befall the state of the operator (civil aviation regulator), which registers the aircraft. In a wet lease, such responsibilities, not necessarily, but may be shared between the regulators of the lessee and the lessor considering various practical aspects. Chicago Convention, Article 83 bis, provides for such an arrangement. Under regulations, the regulator is empowered to issue regulatory permits, such as certificate of airworthiness, noise certificate, and preemptively an Air Operator Certificate/Operating Permit (AOC/AOP) to the operator. An AOC/AOP is the operating permit that authorizes an airline to operate commercial flights. The AOC/AOP is the reflection of the safety and other aviation compliance commitment of the operator.
Aviation insurance is essential for an aircraft lease. Aviation insurance includes coverages for legal liabilities and hull loss/damage. Legal liabilities are losses and damages related to passengers, shippers and third parties. For international aviation, regulators require insurance coverage for legal liabilities related to passengers, baggage and cargo as per Montreal Convention 1999 (MC99). Such coverage must include compensation for bodily injury to/death of the passengers and loss and damage of/to cargo and baggage. The insurance should also cover compensations to passengers and shippers related to delays and cancellations of flights and deliveries. Regulators also require insurance coverage for third party legal liabilities. Insurance should also cover bodily injury to/death of airline crew and observers as well as regulatory inspectors and observers.
The owner/lessor of the aircraft requires hull insurance coverage for a variety of risks of loss of or damage to the aircraft during the lease. The agreed hull value for risk coverage should be acceptable to the owner/lessor. Such a value tends to be somewhat higher than the purchase price for various genuine reasons.
Regulatory requirements for domestic aviation insurance contextually varies in each country.
Rental often is a key negotiating factor of an aircraft lease. Rental is, to a large extent, a matter of market function. Market often depends upon seasonality. Natural calamities (epidemic and pandemic situations, earthquake/tsunami), political upheavals, phenomenal technological issues (example B737 Max) and trade cycles make huge impact on market conditions. These are macro factors. Besides, individual urgency and need of the prospective lessor and lessee play a role in rental negotiation.
Upon fulfilling the conditions agreed in the contract, the aircraft is delivered by the lessor to the lessee at an agreed airport. The delivery-ferry flight may or may not be required on a case to case basis. If a delivery-ferry flight is required, then the two parties have to agree upon the operational and financial responsibilities of the flight. This matter has to be clarified and agreed upon for the redelivery-ferry flight, too.
An aircraft lease viewed as a process is a chain of pre-delivery, delivery and re-delivery of the aircraft. Pre-delivery involves the exchanges of information between the prospective lessor and lessee. Such information may include: a company fact sheet, audited financial reports, a business plan, incorporation certificate, operating permit, credit rating information, aircraft details, operating environment, planned aircraft operation, etc. A kind of mutual due diligence. During this process, business negotiation takes place, which culminates into a mutual understanding between the prospective lessor and lessee. Such understanding is termed as a letter of intent (LOI) or a memorandum of understanding (MOU) or general terms and conditions sheet (GTC). In this write up, we use the term, LOI, for the purpose of convenience. An LOI, generally enlists key points of agreements between the lessor and lessee. Common key points are enlisted below. Some of these points may appear in the lease contract rather than in the LOI as the contracting parties prefer:
LOI key points
- Parties, their signatories and beneficiaries
- Aircraft details, such as its make and model, engines, landing gears and other parts, aircraft manuals, history of the aircraft and parts (in case of an old aircraft) etc.
- Commitment money, security deposit, rental advance, regular rental, mode of payment, banking details of the lessor and lessee
- Responsibilities for safe operation and maintenance of the aircraft
- Regulatory oversight responsibilities and governmental approvals
- Registration of the aircraft and the right of the operational control of the aircraft
- Insurance for passengers, baggage, cargo, crew, delays, inspectors, observers, third parties and hull
- Conditions precedent and conditions subsequent
- Delivery and redelivery conditions
- Force majeure conditions
- Beneficiaries’ entitlements
- Lease period
- Exit clauses
Types of aircraft lease
We can categorize an aircraft lease as follows:
- Finance or capital lease
- Operating lease
- Dry lease
- Wet lease (ACMI) and damp lease
Finance (capital) lease
A finance lease is a lease that “transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred.” A finance lease for its nature of financing arrangements is largely a concern for customs and taxation. Such a lease for the purpose of operation and maintenance of aircraft is that of a dry lease. That means the aircraft under the lease is registered in the state of the operator-lessee. The registration name and nationality of the aircraft are of the state of the operator and are endorsed in the AOC of the operator-lessee.
There are examples or situations that individually or in combination would result in the classification of a finance lease:
- the lease transfers ownership of the asset to the lessee by the end of the lease term
- the lease provides for a bargain option for lessee to purchase the asset at such a price that it is reasonably certain from the outset that the option will be exercised
- the lease term is for the major part of the economic life of the asset even if legal title is never transferred
- at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset (>90%), and
- the leased assets are of such a specialized nature that only the lessee can use them without major modifications.
Other indicators of situations that would result in the classification of a finance lease are:
- the lessor’s losses associated with the cancellation are borne by the lessee
- gains or losses from the fluctuations in fair value of the residual at the end of the lease accrue to the lessee
- the lessee has the option to extend the lease for a secondary period at a nominal rent.
An operating lease is a lease other than a finance lease. It includes all leases of dry, wet and damp nature. Such a lease characterizes non-ownership rights and responsibilities on the part of the lessee. Instead operating and/or commercial rights and responsibilities arises for the lessee in a string together with the lease contract.
A dry lease is an operating lease of an aircraft. It involves rental of an aircraft for a specific period generally ranging from 3 to 12 years. As suggested by its foregone definition, a dry lease doesn’t involve the purchase of an aircraft in lease. The aircraft is leased only for its operation by the lessee. The term, ‘dry’ is commonly understood to include the rental of the aircraft only. A dry lease doesn’t include crew, maintenance, and aviation insurance. Under dry lease, an aircraft is registered with the civil aviation authority of the lessee of the aircraft. The aircraft is registered in the AOC of the lessee as its operator. The lessee has operational and commercial control of the aircraft and uses its designator code and traffic rights for the operation of the aircraft.
In a dry lease, the owner or lessor retains the ownership right on the aircraft. Such a right is internationally re-asserted to the owner through Cape Town Convention. The lessee has the operational control of the aircraft. ICAO defines ‘operational control’ as the right of initiating, conducting and terminating the flight of the aircraft. The aircraft is operated under the registration number and marks allocated by the state of the operator-lessee.
A dry lease has various dimensions for various stakeholders.
A lessee-airline requires a comprehensive plan and arrangement for the recruitment, training and retention of cockpit, cabin, maintenance and dispatch team, development of systems and execution commitments, putting in place safety and security arrangements for the operation and maintenance of the aircraft according to regulator’s minimum requirements. An airline generally has a comprehensive business plan for making an aircraft lease-in decision. Such a plan includes various aspects, including commercial, operational, maintenance, dispatch, safety, quality assurance, finance, human resources, catering, etc.
Wet lease and damp lease
A wet lease is a comprehensive lease. The lessor provides aircraft, crew, maintenance and insurance to the lessee; this kind of lease is commonly known as ACMI lease. Airlines, generally, opts for an ACMI lease for a short term. Examples for a need of an ACMI lease may be: a) when there is a seasonal upswing in the market demand, b) when the aircraft in the operational fleet goes for extended maintenance and therefore a replacement aircraft is required during the maintenance period, c) when an aircraft delivery is delayed, d) due to an incident or accident, an aircraft goes out of operation and a quick replacement is required.
A wet leased aircraft is operated under the AOC of the lessor-operator. That means it carries the registration of the state of the lessor-operator. The operational control of the aircraft lies with the lessor-operator. The lessee has right to commercial control or the aircraft is scheduled for operation as per the commercial requirements of the lessee.
Under a wet lease, insurance coverage for hull insurance, crew, inspectors/observers and third party liabilities remains a responsibility of the lessor-operator. The lessee is generally responsible for insurance covering commercial liabilities for passengers, cargo and baggage. It is a common practice that accommodation, per diems, and commuting of the crew are arranged by the lessee.
A damp lease has a slight change in an ACMI lease. By and large, it is a form of a wet lease. It includes cockpit crew of the lessor-operator and cabin crew of the lessee.
Leasing has catalyzed the growth of the airline industry over the world. Aircraft lease has been quite common a business phenomenon. For a third world country lacking capital, like Nepal, leasing is a growth-booster. Flexibility in lease-in and lease-out promotes capital productivity.
FITTA (Foreign Investment and Transfer of Technology Act) has constrained aircraft leasing in our country. Government should encourage aircraft leasing (both in and out) for the growth of the industry. Removing FITTA related hurdles for aircraft leasing would smoothen the growth of the industry in our country.
By Vijay Shrestha
(Former President of Airlines Operators Association of Nepal)
Other articles by Mr. Vijay Shrestha