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Cross-Border Aircraft Leasing: Dialectics and Dimensions

By Andy OJI1

The Concept of Cross-Border Aircraft Leasing

Cross-border lease which is also sometimes referred to as international lease is

any kind of lease transaction, whether operating lease or financial lease, where

the lessor, the lessee and other related parties are located in two or more

different countries or come from different legal systems. It is also a cross-border

lease where, following a lease transaction, the place of aircraft registration and

the place of operation of the aircraft or the aircraft operator's place of business

are in different countries or subject to different legal and accounting regimes.

Aircraft leasing provides a good example of cross-border leasing because usually

several financial institutions from different countries provide funds to a lessor for

purchase of an aircraft and the lessor leases the aircraft to an airline in another

country. Significant proportion of worlds’ leased aircraft have international or

cross border elements.

Motivating Factors for Cross-Border Leasing

The rising cost of the aircraft asset, the deregulation of commercial aviation,

reduced levels of governmental financial support to airlines, the formation of

airline alliances and the increased use of leasing by airlines to gain operational

flexibility and reduce capital outlays for their aircraft acquisitions resulted in

airlines and aircraft portfolio managers looking to procure aircraft from wherever

the conditions are most favourable. All these factors have given rise to aircraft

leasing transactions across international boundaries. As a result, cross-border

aircraft lease transactions have become customary in the air transport industry

1 Andy Oji is a partner at COSMOLAWS, an aviation law practice based in Lagos, Nigeria. He was the General Counsel of Bellview Airlines and one of Africa’s foremost experts on Aviation law. He has been engaged in aviation and regulatory law practice for 30 years. He is author of yet to be published book titled “International Aircraft Financing and Protection of Investors Rights.”

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and there are some reasons that motivate and drive it in additional to traditional

benefits of domestic leasing.

First, airlines will seek access to capital or financing opportunities from which

ever geographical location provides the best terms such as when foreign airlines

or aircraft portfolio managers seek to access US financial markets through the

Enhance Equipment Trust Certificate and export credit financing of the US Ex-Im

Bank or where foreign airlines seek to access Japanese funding through the

Japanese leverage lease scheme.

Second, lease terms and conditions may be more attractive in foreign

jurisdictions as opposed to domestic markets such as in Japanese Operating

Lease with a call option (JOLCO) which offers competitive or lower lease rates.

Third, some jurisdictions may provide more favourable tax and accounting

benefits than the other for instance, Cayman Island and Bermuda and Ireland,

provides more favourable tax environments for lessors located in their countries.

Ireland has double tax treaties with many countries such that a lessor domiciled

in Ireland will not have to pay withholding tax on its lease rental income from a

lessee.

Cross-border leasing typically seek to take advantage of tax law differences

between the two or more countries involved in the transaction. For instance,

leveraged and tax-oriented cross-border leases can provide other tax

advantages2 because it allows both the lessor and the lessee to be treated as

owner of the leased aircraft for tax purposes and to make depreciations or claim

tax allowances on the leased aircraft, a process known as double dipping.

Apart from the leveraged or tax oriented leases, even in a simple financial or

operating lease, different countries may have different ways of distinguishing

2 For instance, it generally results in the lessee paying less lease rentals when compared with a normal operating lease because the lessor generally transfers a portion of the economic benefit back to the lessee

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between a lease and a secured loan so that it is possible for a transaction to be

structured in such a manner that it is treated as a lease in the lessor’s country

and a secured loan in the lessee’s country. In this situation each party to the

transaction would be considered the owner of the asset in its respective country

and each party would be permitted to recognize depreciation or amortization

deductions for the same aircraft asset.3

The tax benefits of cross border leasing could be considerable for both the lessee

and the lessor even though these benefits have been reduced in recent times in

many countries including the US, Britain, Ireland, Hong Kong and Japan following

reviews of tax laws.

The Problem with Cross Border Aircraft Leasing

The problem with cross border aircraft leasing is that it is a very complex legal

structure, as the funds for the transaction are arranged on a global basis

involving investors or creditors from different countries with diverse legal and

accounting regimes and the collateral, the aircraft, is highly mobile and can be

easily deployed or re-deployed across international boundaries very quickly but

the legal requirements are locally based and can involve a number of local

jurisdictions.

Another problem of cross border aircraft leasing is enforcement of safety

standards particularly where the leased aircraft is registered in one country and

operates in another country. In this scenario the question is which of the

countries involved in the leasing of aircraft across international boundaries shall

be responsible for enforcing International Standards and Recommended

Practices with regard to safe operation of the aircraft. When an aircraft is based

outside its state of registration it becomes difficult for that State to ensure

compliance with maintenance requirements of the aircraft and accordingly to

3 Richard K. Ellsworth, Capital Intensive Assets and Cross-Border Lease Transactions, Journal of Equipment Lease Financing, Spring 1999, Vol. 17, No. 1

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renew the aircraft’s Certificate of airworthiness when required and to renew or

validate crew licenses. All these because indeed while the State of Registry has

only legal control of such aircraft, the actual control lies with the State of the

Operator and it will be unconscionable to hold the State of Registry responsible

for the operation of the aircraft where it does not have actual control of the

aircraft.

Other problems of cross border leasing include non-recognition of title or security

interests in some jurisdictions, differences in forms of security interests and their

ranking, deregistration and export authorization delays, conflict of law risks and

choice of law issues, foreign exchange risk, political or country risks, sovereign

immunity, security of the aircraft and aircraft assets, and weak legal and judicial

systems or deficient commercial legal regimes including bankruptcy and

insolvency laws that impede aircraft repossession in default situations. It is not

uncommon to hear, in some jurisdictions, of pre-emptive arrests and detention of

aircraft under court orders obtained by defaulting lessees to prevent or frustrate

the lessors’ from not only receiving their contractual lease rentals but also from

recovering their aircraft.

Regulation of Aspects of Cross-border Aircraft Lease

There are some important multilateral legal instruments to be considered when

dealing with a cross border or international aircraft leasing and these are:

International Institute for the Unification of Private Law (UNIDROIT) Convention on International Financial Leasing, 1988

The International Institute for the Unification of Private Law (UNIDROIT)

Convention on International Financial Leasing which was adopted in Ottawa on

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the 28th of May 19884 and entered into force on the 1st of May, 1995 (hereinafter

referred to as the UNIDROIT Convention) is an international multilateral

convention designed specifically for the promotion and regulation of some

aspects of cross border leasing (cf. Article 1(1)) particularly financial leasing.

For a lease transaction to be said to be a cross border lease under the

UNIDROIT Convention, the places of business of the lessor and the lessee

should be situated in different States and that either both these States and that

where the supplier’s, the third essential party to the cross border lease, place of

business is located should be Contracting States (cf. Article 3(1)(a)) or both the

supply agreement and the leasing agreement are governed by the law of a

Contracting State (cf. Article 3(1)(b)).

Importantly, the UNIDROIT Convention governs only financial leasing transaction

which is described as a transaction in which, first, the lessee specifies the

equipment and selects the supplier without relying primarily on the skill and

judgment of the lessor. Second the equipment is acquired by the lessor in

connection with a leasing agreement which, to the knowledge of the supplier,

either has been made or is to be made between the lessor and the lessee and

Third, the rentals payable under the leasing agreement are calculated so as to

take into account in particular the amortisation of the whole or a substantial part

of the cost of the equipment (Article 1 (1) and (2)). The UNIDROIT Convention is

still applicable whether or not the lessee has the right to purchase the equipment

4 The Contracting Parties to the UNIDROIT Convention as at 28th June 2017 are Belarus (date of accession: August 18, 1998); Belgium, Czech Republic, Finland, France (date of approval: September 23, 1991); Ghana, Guinea, Hungary (date of accession: May 7, 1996); Italy (date of ratification: November 29, 1993); Latvia (date of accession: August 6, 1997); Morocco, Nigeria (date of ratification: October 25, 1994); Panama (date of ratification: March 26, 1997), Philippines, the Russian Federation (date of accession: June 3, 1998), Slovak Republic, Tanzania, Ukraine (date of accession: December 5, 2006) and Uzbekistan (date of accession: July 6, 2000). With regard to the French Government’s approval and the Russian Government’s accession, it should be noted that France and the Russian Federation, in becoming Parties to the UNIDROIT Convention, both availed themselves of the reservation contained in Article 20, the effect of which is that they will substitute their domestic law rules for the provisions of Article 8(3).

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or extend the lease period, and "whether or not for a nominal price or rental

(Article 1(3)).

Financial leasing under the UNIDROIT Convention is a complex and distinctive

tripartite or triangular relationship involving a lessor who advances funds for the

purchase of the equipment which constitutes the subject of the leasing

transaction, a lessee who selects the equipment and pays a rental fee for the

right to use it, and a supplier who sells the equipment to the lessor.5

The UNIDROIT Convention sets forth the basic structure of the financial lease to

which the Convention applies (Article 1(1)(a)(b)(c)). It states that the lessee shall

provide the equipment specification to the lessor who then using those

specifications, enters into a supply agreement with the supplier to obtain the

equipment for lease to the lessee. The supply contract between the lessor and

the supplier must be on terms approved by the lessee insofar as they concern its

interests. The lessor then enters into a lease agreement with the lessee, granting

to the lessee the right to use the equipment in return for the payment of rentals.

Financial leasing structure under the UNIDROIT Convention involves the

interaction of two separate but interrelated agreements; a supply agreement

between the supplier and lessor and a leasing agreement between the lessor and

lessee.

All the parties to a cross border financial lease transaction may agree to

completely exclude the application of the UNIDROIT Convention to their

transaction and where the application of the Convention has not been excluded

the parties may, in their relations with each other, derogate from or vary the effect

of any of its provisions. The only exceptions to this right to derogate or vary are

lessor's warranty of quiet possession-intentional or grossly negligent acts of the

5 David A. Levy, Financial Leasing Under the UNIDROIT Convention and Convention And The Uniform Commercial Code: A Comparative Analysis, Ind. Int’l & Comp. L. Rev., Vol. 5:2

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lessor (Article 8(3), lessor's damages in the event of default by lessee (Article

13(3)(b) and acceleration of rentals due (Article 13(4)).

Consumer leasing transactions and leases purely of real estate are explicitly

excluded from the UNIDROIT Convention (Articles 1(4) and 4(2)). According to

Martin Stanford, Senior Research Adviser of UNIDROIT, this is because of the

limited instances of consumer leasing at the international level, and the

impracticality of intertwining real and chattel property concepts into a single,

uniform international law.6

In view of the complexity and sophistication of aircraft deals, parties involve

various experts to structure their transactions the best way it suits them usually

waiving rules, laws, conventions and international legal instruments that will

derogate from their intended structure and usage and regrettably, this renders the

UNIDROIT Convention irrelevant even in aircraft financial leasing transactions.

Article 83bis on Transfer of Certain Functions and Duties As a result of the phenomenal growth and development of leasing, airlines are

leasing their aircraft from countries outside the countries of their habitual base.

These cross border aircraft leasing results in structural and complex regulatory

issues not envisaged at the time of or provided for by the Chicago Convention.

The structural issues are; where the aircraft could be the property of one legal

entity and be operated by another simultaneously and where the aircraft is

registered in one jurisdiction and operated in another jurisdiction. On the other

hand, the complex regulatory question raised by cross border leasing is which of

the country of registration or operation of the aircraft will be responsible for safe

operation of the aircraft, for the international good conduct of the aircraft and

compliance with International Standards and Recommended Practices when it

operates beyond its national boundaries. It was in order to accommodate this

6 For a full commentary on the provisions of the UNIDROIT Convention see M.J. Stanford, “The UNIDROIT Convention on International Financial Leasing adopted in Ottawa on May 26, 1988” in World Leasing Yearbook 1989, pages 58 and 61–67

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growing practice of leasing and similar arrangements and to ensure adequate

regulatory oversight with respect to the operation of the aircraft that the special

Article 83bis7 was inserted into the Chicago Convention. This amendment

enables the country in which the aircraft is registered to transfer or delegate its

functions and duties towards the safe operation of the aircraft under the Chicago

Convention to the country where the aircraft is operated. The model transfer

agreement developed by ICAO to enable this transfer is set out in Guidance on

the Implementation of Article 83bis of the Convention on International Civil

Aviation.8

Registration and Nationality of Aircraft

Registration and nationality of aircraft are important with respect to Article 83bis

because from these legal relationships specific rights and obligations are derived.

The Chicago Convention is replete with provisions dealing with registration of an

aircraft. Article 17 provides that an aircraft shall have the nationality of the state in

which they are registered. Article 18 prohibits the registration of aircraft in more

than one State. Article 20 provides that every aircraft engaged in international air

navigation shall bear its nationality and registration marks and Annex 7 of the

Chicago Convention requires that the nationality and registration mark be painted

on the aircraft. Article 21 mandates each contracting State to provide on demand

to any other contracting State or ICAO information concerning the registration

and ownership of any aircraft registered in the State and Article 29 requires every

aircraft of a contracting State engaged in international navigation to carry among

other things, its certificate of registration.

Even though there is no specific provision in any international air law instrument

mandating registration of aircraft, it is the contention of this author that the

7 “bis” means that this provision was inserted in the Convention after Article 83 8 Published by ICAO February 2003, at page 9-14.

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necessary implication of the combined effect of Articles 17, 18, 20, 21 and 29 of

the Chicago Convention and indeed the Customary international air law is that

every aircraft involved in air navigation in terms of the Chicago Convention

particularly international air navigation shall be registered9 and once registered

shall have the nationality of the State in which it is registered.

It has however been contended that the registration of aircraft is not so much a

source but a proof of the nationality of aircraft10 but this author is of the view that

registration of aircraft is indeed the source of its nationality and not otherwise and

contends that even though the concept of nationality of aircraft had already

crystallized into customary international air law and nationality was ascribed to

aircraft on the basis of its habitual base or domicile or nationality of its owners

prior to the Chicago Convention, the reality is that under today’s international air

law jurisprudence, it is the registration in a state’s aircraft registry that determines

the aircraft’s nationality.11 Therefore nationality of aircraft is rather derived from its

registration and not from any other source so much so that an aircraft is devoid of

nationality if it is not registered.

The fact of registration implies responsibility of the State of registration for safety

of aircraft registered with it, wherever those aircraft may be operated12 and this

responsibility extends to ensure that those aircraft are well maintained according

to the minimum safety standards.

Nationality of aircraft is very central to air navigation because the flag-state or the

country in which the aircraft is registered must ensure that every aircraft listed on

its registry complies with the laws, rules and regulations that apply to the flight of

aircraft, regardless of where the aircraft may be operated and any violation of this

9 Similar sentiments were expressed by the International Law Association Helsinki Conference 1966, at page 29 of its Report on Nationality and Registration of Aircraft with Special Reference to Article 77 of the 1944 Chicago Convention on International Civil Aviation. 10 See Cooper, “The Chicago Convention-After Twenty Years” in Explorations in Aerospace Law edited by I.A. Vlasic (McGill University Press 1968) 438 at 443. 11 Article 17 of the Chicago Convention 12 International Civil Aviation Organization, Guidance on the Implementation of Article 83bis of the Convention on International Civil Aviation, February 2003.

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responsibility will be a matter of prosecution pursuant to Article 12 Chicago

Convention. It means that the State of Registry is responsible for the aircraft’s

compliance with rules of the air,13 for its general safe operation and manoeuvre,

for the international good conduct of the aircraft and compliance with International

Standards and Recommended Practices when it operates beyond its national

boundaries.

The importance of an aircraft's nationality lies in a number of functions which the

Chicago Convention has entrusted to the state of registration such as the

responsibilities to provide the aircraft and flight crew with radio license,14 to

determine the airworthiness and conditions of the aircraft in its register, to issue

or validate Certificates of Airworthiness, ensure continued airworthiness of the

aircraft,15 determine that the required personnel are adequately qualified to

perform their duties, issue and validate personnel licenses and ratings, approve

training programmes and flight simulators used for type ratings16 and take timely

actions to correct safety issues and the responsibility of safe operation of the

aircraft.

These duties of the State of Registry extends to assure other States that aircraft

bearing its insignia or registration marks will conform to the flight regulations of

any State wherever or over which they fly and that it is also in charge of

overseeing the airworthiness of the aircraft, the competence of the flight crews

and the operation of the aircraft radio equipment. Under the Chicago Convention,

the State of Registry is considered to be a guarantor accountable to the

international community for the safe operation of aircraft bearing its registration

mark and will be responsible if the aircraft violates any rules of safe operation.

13 Article 12 of the Chicago Convention 14 Article 30 of the Chicago Convention 15 Article 31 of the Chicago Convention 16 Article 32(a) of the Chicago Convention

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The Need for Article 83bis

It was in response to the safety implications associated with international aircraft

leasing and sometimes the movement of air carriers’ operational bases across

national boundaries otherwise flag of convenience airlines17 that the international

aviation community developed Article 83bis of the Chicago Convention18 to fill

this great need that was unforeseen at the time the Chicago Convention was

drafted. The adoption of Article 83bis reflects the adaptability of the Convention to

the reality, development and growth of the global commercial aerospace industry.

Article 83bis assists with the structuring of cross border aircraft transactions by

providing interested parties (and in particular lessors and financiers), with a

mechanism for increasing the regulation and safety oversight of an aircraft that is

operated from a state perceived as high risk.

The Purpose of Article 83bis

The purpose of the Article 83bis was not just to ensure safe operation of aircraft

in cross border lease or to regulate the obligations of the State of Registry and

State of Operator with respect to aircraft leased across international boundaries it

is also to protect the rights of the State of Registry and that of third states where

the aircraft registered in one State is operated in another State. As a practical

matter, solutions can be worked out under existing international laws where radio

licenses, the certificates of airworthiness and the certificates of crew competency

could be issued by the State of the Operator and are rendered valid by the State

of Registry19 or the State of Registry and State of Operation can conclude a

bilateral agreement transferring the regulatory obligations. But if these options

17 A flag-of-convenience airline is a carrier that is established in a country other than the home country of its majority owner(s) in order to avoid regulations of the home country. 18 Article 83bis of the Chicago Convention was signed at the 23rd session of the ICAO Assembly on October 6, 1980 but it did not enter into force until June 20, 1997 for want of the requisite number of countries to ratify the amendment. 19 Article 23 of the 1959 Radio Regulation enacted by the International Telecommunication Union read together with Article 33 of the Chicago Convention will have the effect to permit that if the State of Registry renders valid radio licenses and certificates of airworthiness or the certificates of crew competency issued by the State of the Operator, these certificates shall be recognized as valid by the other contracting States.

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were adopted, the State of Registry will still unavoidably remain fully responsible

to other Contracting State parties to the Chicago Convention for those duties

which it is mandated by the Chicago Convention to perform by virtue of aircraft

being registered in that state and such bilateral agreement will not protect third

States because of the principle encapsulated in the maxim pacta tertiis nec

necent nec prosunt (agreement have no effect on third parties), a principle

embodied in Article 34 of the Vienna Convention20 which stipulates that a treaty

does not create either obligations or rights for a third State without its consent.

Therefore Article 83bis as a multilateral Convention provides for the most

effective way to transfer the responsibilities of the State of Registry to the State of

Operation in cross border aircraft leasing.

Scope of Article 83bis

Article 83bis is the first substantive amendment to the Chicago Convention21 and

its immediate objective was to solve the situation arising, inasmuch as the

functions of the registration states are concerned, when aircraft of its nationality

are being used by an operator whose place of business or domicile lies in the

territory of another state. It provides that where an aircraft registered in a

contracting state is operated in another contracting state pursuant to a lease

charter or interchange of the aircraft or any similar arrangement, the state of

registry may by agreement with the state where the aircraft is operated transfer or

delegate all or part of its functions with respect to that aircraft to that other state.

The full text of Article 83bis is as follows:

"Article 83bis

Transfer of certain functions and duties

(a) Notwithstanding the provisions of Articles 12, 30, 31 and 32(a),

when an aircraft registered in a contracting State is operated

20 Vienna Convention on the Law of Treaties.

21 International Civil Aviation Organization, Guidance on the Implementation of Article 83bis of the Convention on International Civil Aviation, February 2003

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pursuant to an agreement for the lease, charter or interchange of

the aircraft or any similar arrangement by an operator who has his

principal place of business or, if he has no such place of business,

his permanent residence in another contracting State, the State of

Registry may, by agreement with such other State, transfer to it all

or part of its functions and duties as State of Registry in respect of

that aircraft under Articles 12, 30, 31 and 32(a). The State of

Registry shall be relieved of responsibility in respect of the functions

and duties transferred.

(b) The transfer shall not have effect in respect of other contracting

States before either the agreement between States in which it is

embodied has been registered with the Council and made public

pursuant to Article 83 or the existence and scope of the agreement

have been directly communicated to the authorities of the other

contracting State or States concerned by a State party to the

agreement.

(c) The provisions of paragraphs (a) and (b) above shall also be

applicable to cases covered by Article 77.”22

Aircraft Interchange or Interchange Flight

It is important to clarify that lease, charter or interchange or any similar

arrangement present the same regulatory complexities in international air

navigation because in all three arrangements, an aircraft under the regulatory

supervision of one country i.e. the State of Registry will be operated under the

regulatory supervision of another country i.e. the State of Operator. For instance,

22 Protocol Relating to an Amendment to the Chicago Convention on International Civil Aviation, signed at Montreal on 6 October 1980, ICAO Doc. 9318 [hereinafter Article 83bis Protocol].

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an aircraft interchange23 or interchange flight is a regularly scheduled, single-

plane through service linking a route of one air carrier at the interchange point to

a route of a second air carrier, with the same aircraft being crewed by and under

the operational control of the respective authorized carrier on each route.24 It is

an interchange, for instance, where Air New Zealand flies with an A380-800

aircraft from Auckland to San Francisco (as an Air New Zealand flight) from

where British Airways will take over the same aircraft to fly it as British Airways

flight from San Francisco to London. An interchange provides passengers with a

benefit of a single-plane service on what is essentially an interline operation and

may provide additional benefits to the carriers involved in terms of better aircraft

utilization as maximum use is made of extremely expensive aircraft.25

The Substantive Elements of Article 83bis

There must be an agreement of lease, charter or interchange of aircraft or

any similar arrangement.

The aircraft must be registered in a contracting State.

The State of the Operator must be a contracting State other than the State

of Registry, and

There must be an agreement between the two States transferring the

responsibilities under Articles 12, 30, 31 and 32(a) from the State of

registration to the State of operator.

23 Aircraft interchange is a specific type of dry lease which is an agreement between air operators in which the operational control of an aircraft is transferred for short periods of time from one air operator to another. With this type of agreement, the latter air operator assumes responsibility for the operational control of the aircraft at the time of transfer. 24 International Civil Aviation Organization, Guidance on the Implementation of Article 83bis of the Convention on International Civil Aviation, February 2003, at page 1 referring to The Manual on The Regulation of International Air Transport (Doc 9626). 25 The A380 aircraft was initially offered in two models: the A380-800 and the A380F. The A380-800's original configuration carried 555 passengers in a three-class configuration or 853 passengers (538 on the main deck and 315 on the upper deck) in a single-class economy configuration. Its unit cost as at 2018 was US$445.6 million. It has a range of 15,400 km and cruises at top speed of 1,050 km/h.

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Functions and Duties to be transferred under Article 83bis

The operation of aircraft engaged in international air navigation is governed by

the requirements specified in Annex 6 to the Chicago Convention dealing with

International Standards and Recommended Practices relating to the operation of

aircraft and it is the responsibility of the State of Registry to ensure that all aircraft

listed on its register comply with these requirements. Therefore when the

responsibility of the State of Registry is transferred to the State of operation

pursuant to Article 83bis, what are transferred indeed are the obligations of the

State of Registry under Annex 6. This is the reason Article 83bis transfer is

popularly referred to or regarded in the industry as Annex 6 transfer or

delegation.

The specific functions and duties that may be covered by the transfer are rules of

the air,26 radio licensing,27 Certificate of Airworthiness28 (the Certificates of

Airworthiness are to be issued in accordance with the standards established in

Annex 8) and licenses of personnel29 (the relevant licenses of personnel are to be

issued in accordance with the standards established in Annex 1).

Article 83bis is an enabling provision the ratification of which does not entail

automatic transfer of functions and duties from the State of Registry to the State

of Operator. It requires that such transfer be expressly arranged through an

agreement between the parties involved. The question whether to transfer

function and duties relating to regulation of aircraft operation in cross border

leasing remains entirely optional and discretionary and any agreement can only

be with respect to specific mentioned functions and duties of which all or some

can be transferred.

26 Article 12 of the Chicago Convention 27 Article 30 of the Chicago Convention 28 Article 31 of the Chicago Convention 29 Article 32(a) of the Chicago Convention

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The Procedure for Consummating Article 83bis Transfer

Under Article 83 bis, a bilateral agreement can be signed between the aviation

authorities of two contracting states. The bilateral agreement transfers and

delegates the responsibility for the regulation and safety oversight of an aircraft in

accordance with the requirements of the state of registration from that state to the

air transport authorities in the airline’s new home state or state of operator.

The procedure for Article 83bis application and approval requires the operator of

the aircraft in the State of Registry, usually an AOC holder, wishing to lease out

an aircraft to an operator in another jurisdiction necessitating the transfer or

acceptance of safety oversight responsibilities to or from another contracting

state to submit an application to the State of Registry indicating the likelihood of

transferring oversight duties and responsibilities to the state of operation.

The State of Registry will evaluate the state of operation’s capacity, capability

and competence to undertake the effective safety oversight functions of the

aircraft in question. Upon successful completion of the evaluation process, an

article 83bis agreement will be drawn up and signed by the two state authorities.

The signed agreement shall be communicated to the ICAO council for publication

or to other contracting states which may be affected by the transfer. The state of

registry should however, be permitted unrestricted access to the aircraft at any

place and time, although it has been relieved of responsibility in respect of

functions and duties transferred

Effect of the Article 83bis Transfer

Once Article 83bis transfer has been published and made public by the ICAO

Council, it shall have effect on all contracting States (Article 83bis, paragraph (b))

otherwise it will not have effect against third parties.

The result is that if Article 83bis transfer is consummated i.e. if the elements laid

down in Article 83bis paragraphs (a) and (b) are satisfied,

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The State of Registry is relieved of those responsibilities transferred to the

State of Operator.

All other States would recognize the transfer of responsibility.

The State of Operator shall then on assume full regulatory obligation and

become internationally responsibilities and liable for those function and

duties transferred.

The transfer of supervisory functions and duties that are normally the

responsibility of the State of Registry should make international air navigation

safer since the Sate of Operator which is the state having the closest ties with the

operator will have the supervisory authority to carry out safety oversight of the

aircraft and its crew in accordance with the relevant Annexes to the Convention.

Under Article 33 of the Chicago Convention, Contracting States must recognise

the validity of each other’s Certificate of Airworthiness and crew licenses30

provided that the condition of issuance meet the minimum requirements

established by Annex 1 and Annex 8 on the standards governing personnel

licensing and airworthiness of the aircraft respectively. It therefore means that if

the authority to issue these certificates and licenses are formally transferred or

delegated to the State of Operator, then the Contracting States that have ratified

Article 83bis will be obligated to recognise the validity of these certificates and

licenses when they are issued or rendered valid by the State of Operator, if they

have been officially informed of the transfer.

30 This include those rendered valid by the Contracting States

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Reason Article 83bis is not widely used

Article 83bis transfer is not widely used in the industry. As at November 20, 2002,

only 25 transfer agreements involving only 5 registering parties; Kenya, Ireland,

Italy, Bermuda (U.K) and Malawi, had been registered with ICAO.31

The reason Article 83bis is not widely used could be that the process for the

transfer or delegation of functions and duties pursuant to Article 83bis is daunting

for air carriers because it involves negotiations and slow diplomatic back and

forth exchange between two States who must be willing, either of which may

refuse the transfer or impose stringent conditions which may affect the

commencement of the lease or result in the lease expiring before the process of

transfer is completed. It could also be as Donal Patrick Hanley suggested in his

very compelling treatise on aircraft operating lease32 that the State of Operator

has no motivation in accepting such responsibility.

Alternative to Transfer of Functions and Duties in a Cross Boarder Lease

What this author has experienced in practice with respect to transfer of certain

functions and duties under Article 83bis in cross border aircraft leasing is that

substantial number of these bilateral agreements are not notified to ICAO but are

directly communicated to the authorities of the other Contracting State(s)

concerned with or affected by the aircraft lease by a State Party to the agreement

in accordance with paragraph (b) of Article 83bis and the aircraft are in many

cases subject to split oversight responsibility.

Except where parties involved in a cross border aircraft lease specifically agree

for whatever reason to retain the registration of the aircraft or to register the

aircraft in a state other than the state of operator or for the aircraft to be under the

cover of a flag of convenience, one sure way to avoid transfer of functions and

duties as directed by Article 83bis in a cross border lease without contravening 31 See International Civil Aviation Organization, Guidance on the Implementation of Article 83bis of the Convention on International Civil Aviation, February 2003, at page 23 32 Donal Patrick Hanley, Aircraft Operating Leasing, Wolters Kluwer, 2012 at page 148

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the requirements of the Chicago Convention is to first de-register the aircraft at

the State of Registry and then obtain a fresh registration at the State of Operator.

This procedure must be followed methodically because an aircraft cannot be

validly registered in more than one State but its registration may be changed from

one State to another.33

Major issues facing international commercial aviation

There are three very controversial issues facing international Commercial

aviation that deserve extended discussion within the context of international

aircraft leasing and they are: the recent emergence of flag of convenience in

international aviation, the increasingly controversial use of Export credit Agencies

by some airlines to the exclusion of others in the acquisition of large aircraft and

the growing problem of government subsidies in international aviation. The

problem of government subsidies is outside the scope of this work.34

Flag of Convenience in Aviation Context

Abeyratne in his very incisive essay on registration of aircraft35 argued that the

concept of Flag of convenience is a misnomer in aviation context and the

rationale for his position may be that unlike in maritime industry where ships fly

the flags of the countries in which they are registered, aircraft do not fly fags. This

author is of a contrary view because if we consider that even though aircraft do

not fly physical flags as ships do but that today flags of the countries where the

aircraft are registered are in some cases painted on the airframe, it may not be a

misnomer after all to regard the concept of Flag of convenience as a misnomer in

aviation context. More importantly, the concept is as relevant to aircraft as it is to

ships because essentially, the reference to flag of convenience in relation to

aviation is not so much of a reference to a physical flag but a reference to

33 Article 18 of the Chicago Convention 34 For discussion of the problem of government subsidies in international commercial aviation, see the upcoming book by this author titled “International Aircraft Leasing.” 35 Ruwantissa Abeyratne, Registration of Aircraft: Legal and Regulatory Issues, Annals of Air and Space Law, 2009 Volume XXXIV, page 186

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registration of an aircraft in a country different from the country where it is

operated or habitual based or a reference to an aircraft with a foreign registration

and nationality.

The concept of Flag of convenience also known as forum shopping-scheme in

relation to foreign registered aircraft is not defined in any international air law

instrument. But leaning on the experience in the international maritime industry

from where it originated, it may be defined as the registration of an aircraft in a

country other than that in which it is domiciled or habitually based in order to

avoid certain unfavourable regulations in its home country and by so doing

choose a convenient and beneficial regulatory authority to superintend over its

operations. It is also the registration of an aircraft in a foreign jurisdiction that

offers the most convenient and business-favourable laws governing aircraft

crews, taxes, regulatory oversight and other aspects of aircraft operations.

The reason for registration of an aircraft in a jurisdiction different from where it is

operated may not only be for convenience i.e. to circumvent unfavourable

regulations or to seek the most business friendly jurisdiction, it may also be out of

preference or other operational exigencies or necessitated by the circumstances

of a cross border lease where an aircraft registered in the country of a lessor is

leased out to and operated by an airline in another jurisdiction.

Over the years, some countries such Panama, Cyprus, Mauritius, Liberia, Aruba,

Bermuda, Ireland36 and others have started to allow open registries or aircraft

registries of convenience and will for a fee or other incentives allow an aircraft

owner or operator to place an aircraft on their register without the usual residency

or citizenship requirements, a practice frowned at by the international commercial

aviation community.

36 Ireland openly prides itself as being a “tax haven” state with a corporate tax rate of only 12.5% and virtually non-existent labour laws. There are also the increasingly popular secret tax deals known locally as the “Double Irish” where foreign corporations that reincorporate in Ireland are given even lower tax rates. Ireland may well be the new and first flag of convenience country in international aviation.

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But it seems that the aviation industry may now be ready to embrace this practice

in view of the granting of a Foreign Air Carrier Permit to Norwegian Air

International (NAI) by the US Department of Transport (US DoT) in December

2016 to operate international air services between Europe and the US, a move

vocally supported by the EU. In this case, Norway’s flag carrier, Norwegian,

established NAI as an Irish based subsidiary in order to circumvent bilateral route

restrictions and the Norwegian labour laws, labour unions or take advantage of

less-restrictive labour and regulatory laws in Ireland.

Clearly, NAI is operating under the cover of Irish flag of convenience to

circumvent bilateral route restrictions and the Norwegian labour laws. Ireland is a

member of the EU and Norway is not. Norway enjoys "open skies" route

agreements with the United States and also with Europe, but not between the

two. This means that a Norwegian airline cannot operate a direct flight between

Europe and the US. For instance, Norwegian (the parent company of NAI) cannot

originate a direct flight service between Barcelona and New York because of

bilateral route restrictions but by setting up NAI in Ireland that holds an Irish Air

Operators Certificate (AOC) and domiciled in Dublin, NAI became an EU airline

and can therefore exploit EU and US open skies. On the other hand, by flagging

in Ireland, NAI is able to use flight crews employed under contracts governed by

the laws of various Asian countries, including Singapore and Thailand.

In granting the Foreign Air Carrier Permit to NAI, a move openly supported by the

EU, the EU and US authorities seems to have given an official seal of approval

for the practice of flag of convenience and may have unwittingly signalled that a

new era in international commercial aviation has arrived: one in which airlines

shop around for friendly tax and labour legal regimes and friendly regulatory

oversight regimes for the registration of aircraft or to move their operational

bases. It means that under present laws and treaties, a non-EU airline can set up

an Irish subsidiary airline and can then fly from anywhere in Europe to anywhere

in the US, skirting completely around whatever restrictive bilateral restrictions that

was previously in the way.

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Categories of flag of convenience

Essentially, there are about four broad categories of foreign registered aircraft

that can be seen to operate under the cover of a flag of convenience.

The first category is those that are registered to explore or exploit market

access or circumvent bilateral or multilateral route restrictions.

The second category is those that are registered to avoid financial charges

or to take advantage of low tax or other favourable fiscal regulations in a

particular jurisdiction or to avoid labour standards in the airline’s home

country. By registering in a foreign country, aircraft owners will avoid

paying taxes in their home countries and instead pay only the far more

modest taxes if any imposed or required by their adopted foreign flags and

governments.

The third category is those that are registered to circumvent restrictive

regulatory oversight by registering an aircraft in a country with minimal or

nonexistent regulatory supervision and

The fourth category is the flag of convenience airlines where air carriers’

move their operational bases across national boundaries and register their

aircraft in those jurisdictions. Such as the recent Norwegian registration of

Norwegian Air International in Ireland.

All four categories in which flag of convenience arises are of major concern to the

global air transportation industry but it is the third category that may have the

greatest propensity to compromise aviation safety and this has given the practice

of Flag of convenience a negative connotation and has sometimes led to foreign

registered aircraft being viewed with suspicion.

Surprisingly, a significant proportion of the worlds’ aircraft fleet are registered

under the flags of convenience that can be compartmentalized under one of

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those four broad categories. It is hoped that the implementation of transfer or

delegation of functions and duties pursuant to Article 83bis by the relevant civil

aviation authorities, the application of ICAO Universal Safety Oversight Audit

Programme (USOAP) and the highly effective IATA Operational Safety Audit

(IOSA) which is an international scheme designed to evaluate and assess the

operational management and control systems of airlines, will help check any

safety supervisory lapses that may be created by the use of flag of convenience

for the purpose of circumventing restrictive regulatory oversight in international

commercial aviation.

The Controversial Concept of Home Market Rule in ECA Financing

ECA Financing

While most airlines or aircraft leasing companies typically go directly to lending

institutions in search of aircraft funding, one other avenue of aircraft financing is

through Export Credit Agencies or ECAs. Typically these agencies serve to

guarantee foreign aircraft purchase loans made by private banks. Most

industrialized nations and at least all aircraft manufacturing countries have at

least one ECA. ECAs are usually a government or quasi government agencies or

a division of government trade ministries with the responsibility of developing,

promoting and financing export sales of that nation’s products.37 Others act as

autonomous or even private institutions that operate an official export credit

scheme on behalf of the government.38 One feature common to all the ECAs is

the assumption of the bulk of credit risk inherent in extending finance to foreign

buyers on behalf of the government. The precise terms and conditions of the

financing support available from the individual ECA differ.

37 As of December 31, 2016, there were about 96 export credit agencies worldwide that emphasize export promotion and expansion, despite having a wide range of mandates. 38 There is not a distinctive and typical style export credit agency. Some operate from government departments and others operate as private companies’ but all ECAs typically act on behalf of the State.

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Export Credit Agency is an agency in a creditor country that provides insurance,

guarantees or loans for the export of goods and services while export credit is the

type of credit or financial assistance extended to finance the cross-border

purchase of goods or services. For purposes of our discussion on cross border

aircraft leasing, export credit financing may be defined as credit, guarantees, or

other financing support provided by governments or government owned or

mandated corporations or entities for the specific purpose of facilitating the sale

and export from their countries of aircraft equipment.39

Thus, ECAs are intermediaries between governments and exporters to issue

export financing and are there to provide support or complement bank lending or

commercial financing, such as in cases where banks would be reluctant to

provide the lending or assume 100 percent of the risk of lending. For example,

ECAs often intercedes when a small-medium sized enterprise exporter is unable

to secure upfront capital from private markets for needed materials or inputs to

manufacture a product because technical or political risks make the transaction

uncertain or when a foreign buyer needs financing to purchase the goods or

services from an exporter.

ECAs do not compete with private sector lenders but rather acts as a “lender of

last resort,” responding to a market failure by providing export financing products

that fill gaps in private trade financing.40 Export credit agencies have always

acknowledged that their remit is not to compete with the commercial markets, but

to provide support for the manufacturers when commercial lenders are not able,

or not willing, to accept the risks of the underlying transaction.

So export credit financing is a financial scheme or conduit through which many

countries encourage the export of goods and services manufactured in their

39 Anthony Saunders, Anand Srinivasan, Ingo Walter, and Jeffrey Wool, The Economic Implications of International Secured Transactions Law Reform: A Case Study, 20 U. Pa. J. Int’l L. 309 (1999). 40 Stephen J. Ezell, Understanding the Importance of Export Credit Financing to U.S. Competitiveness, June 2011

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home market or home country.41 Exports are the lifeblood of many of the world’s

economies. The promotion of exports is therefore a critical element of many

countries’ economic policy. As governments seek to expand exports to boost

recovery, export credit agencies are taking on new and expanded roles.

ECAs provide government backed loans, guarantees, insurance or interest rate

support to corporations from their home country that seek to do business or sell

their products overseas and to the foreign buyers.42 The services of the ECAs

help to remove the risk of uncertainty of exporting to other countries and

underwrite political and commercial risks of overseas investments, thus

encouraging exportation and international trade. ECAs are particularly useful in

facilitating deals where there is no established aircraft lending or financing culture

such as in developing countries and emerging markets and this is because

aircraft financing is not the first area local indigenous banks go into.

The major Export Credit Agencies most usually involved in aircraft financing are

the US Export-Import Bank43 which supports the export of Boeing aircraft44 and

other US manufactured aircraft equipment,45 France’s BPI France Assurance

Export formerly Coface,46 Germany’s Euler Hermes47 and the UK’s ECGD48

which guarantees Airbus aircraft49 and other aircraft equipment manufactured in

41 Many governments have reinvented, reinforced, reoriented, and restructured their ECAs to be highly effective strategic partners in support of national growth objectives. 42 Export credit agencies fill gaps in export financing by acting as a lender of last resort. 43 After letting its charter expire in July 2015, the US Congress reauthorised the bank in December 2015, but it is still in a state of limbo because it is not able to conduct new business given it awaits Senate confirmation of members to reconstitute a quorum. Only with a quorum can new funding decisions be made. Source: Professor David Yu, Changing composition of financing sources in aviation, Airfinance Journal February/March 2017. 44 Oftentimes unofficially referred to as the ‘Boeing Bank’ 45 US EXIM Bank Update: While US EXIM Bank has been and remains “open for business” since it’s most recent reauthorization on December 4, 2015 and is currently accepting applications, approvals for financings greater than US$10 million will require a Board of Directors (“BoD”) of three members quorum (“Quorum”), a requirement which remains currently unfulfilled. Source: Munawar Noorani, The Impact of Today’s Multifaceted Financing and Uncertainties, IATA World Financial Symposium, Dublin, Ireland, September 2017. Ex-Im’s charter was reauthorised for a five-year period in December, ending its nearly six-month shut down. However, three of the five seats on Ex-Im’s board remain vacant, so the ECA cannot approve transactions valued at more than $10 million or those lasting for more than a year. 46 Compagnie Francaise d’Assurance pour le Commerce Exterieur also serves Dassault 47 Consortium of Hermes Kreditversicherung Aktiengesellschaft and C&L Deutsche Revision otherwise Euler Hermes 48 Export Credits Guarantee Department 49 European ECAs Update: The ECAs (UKEF, BPI France (formerly Coface), and Euler Hermes) have temporarily halted export

credit support for Airbus aircraft since April 2016 due to an ongoing investigation surrounding previous applications for export credit support by Airbus. Source: Munawar Noorani, The Impact of Today’s Multifaceted Financing and Uncertainties, IATA World Financial Symposium, Dublin, Ireland, September 2017.

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the countries of the ECAs. For Airbus supported ECAs, each ECA provides

export credit finance in proportion to the share of the work in manufacturing

Airbus aircraft,50 with one ECA leading the transaction with the other two provide

support to it, thereby providing Airbus customers with a single portal through

which they can engage ECA support.51 Other ECAs that support aircraft financing

are the Export Development Canada (EDC) that support Bombadier and the

Brazilian Development Bank (BNDES)52 or EXIM Brasil Agéncia Crédito á

Exporta çāo do Brasil S.A that support Embraer.53

The ECA’s have recognized the importance of aircraft manufacturing to their

economies so have supported the export of their aircraft. ECAs from China,

Japan and Russia will become more relevant in aircraft financing as the aircraft

from these countries gain acceptance in the international aviation market. The US

Ex-Im Bank is the world’s largest export credit agency. The other big-three ECAs

are Kexim of Korea, JBIC of Japan and Coface of France.

Historically, the Export Credit Agencies of the key airframe and engine

manufacturing countries, such as the US, UK, Germany, France, Canada and

Brazil, have recognised the importance of aircraft manufacturing to the national

economies. Aircraft manufacturing can be an important economic generator for a

country. Thus governments support their manufacturers by guaranteeing loans

for aircraft exports to cover the losses of commercial banks that were lending to

relatively risky airlines.54 For instance, an airline from a developing country may

want to buy Boeing aircraft. Few banks, however, would be prepared to lend

money to the airline as it does not make large profits and the country is viewed as

50 Airbus aircraft are made in France, Germany and the UK so each government covers the proportion made in their country. The French export credit agency is known as Coface, the German agency is called Hermes and the UK has the Export Credits Guarantee Department or ECGD. Export Development Canada handles bombardier loans and BNDES guaranteed Embraer exports. Typical Export credit loans cover 85% of the aircraft’s value. 51 Agencies can also work together. Airbus deals are typically led by one of the three European agencies. Because Rolls-Royce engines (which are made in the UK) are used on Boeing aircraft, UK Export Finance has also supported Boeing deals. 52 Banco Nacional de Desenvolvimento Econômico e Social (BNDES) 53 On Thursday December 21, 2017 Embraer confirmed that they have been discussing with Boeing about a possible takeover of the Brazilian plane-maker. This report comes about two months after Airbus agreed to buy a majority stake in Bombardier’s C Series aircraft programme. 54 PwC, Aviation finance Fasten your seatbelts, January 2013

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risky. But because it is in it’s the interest that Boeing sell its aircraft, the Export-

Import Bank of the United States (Ex-Im Bank) may guarantee the loan. A bank

will lend the money to the airline but if the airline defaults or is insolvent or

bankrupt and stops paying, Ex-Im Bank will cover the bank’s losses.55

Export credit agencies are major funders of aircraft. In 2010 for instance, about

50% of all Airbus deliveries were covered by export credit agencies. According to

the OECD and Boeing about a third of all financing for commercial aircraft now

comes from export credit. ECAs allocate about a third of their long-term financing

to aircraft sales, the largest representation of any sector. In France for instance,

Airbus alone benefits from 37% of all COFACE guarantees per year. There are

concerns that this heavy reliance on ECAs creates an uneven playing field, as

the smaller airlines are less able to access this kind of finance.

The key point about this source of funding is that commercial banks still provide

the required funding (although this is changing) and ECAs continue to provide

guarantees to make good any specific losses incurred by the funding bank in

case of default. As a consequence, the credit risk for banks is not the airline

anymore but the sovereign risk of the ECA given the collateral.56 The cost of

financing through ECA-backed guarantees has historically been lower than

commercially available bank debt. But the introduction and implementation of the

revised minimum premium rates under the OECD’s 2011 Aircraft Sector

Understanding has increased the cost of export credit agency aircraft financing

thereby bringing Export credit volume to an all-time low in 2016 and 2017.

Forms of Export Credit Agencies Support

ECA financing can take one or more forms, depending upon the exporter’s needs

and the mandates that have been given to the particular ECA. Export credit

financing may be provided as credit or financing support, (i.e. direct

55 ICAO, Financing for Aviation Infrastructure, November 2016 56 PwC, Aviation finance Fasten your seatbelts, January 2013

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credits/financings, refinancing, interest rate support) or “pure cover”57 (i.e.

insurance or guarantees given to exporters or lending institutions without

financing support) or as aid financing (credits and grants). Official credit support

may be provided with the basic guarantee or insurance facility or it may be

provided on a stand-alone basis. Export Credit Agencies can either lend to

foreign importers directly or reduce the risk of them defaulting by guaranteeing

loans made by banks. They are often seen as lenders of last resort and they

have historically been very important during industry downturns or financial

crises.58

Historically, there are basically two broad structures of export credit financing.

The first is credits or financial support and the other is credit insurance and

guarantees. Variants of these two broad structures are developing in the form of

ECA backed letters of credit and ECA backed bonds. So today, it is either that

the ECA provides the cash of a bank or a bond raises the cash or Letters of

Credit and the ECA guarantees repayment.

Functions of Export Credit Agencies

The main purpose of export credit agencies is to facilitate export of goods and

services of business entities from their home market and by so doing create jobs

through exports and contribute to a stronger national economy while not

competing with the private sector financial services providers. Export credit

agencies provide three basic functions.

First, export credit agencies are conduits through which many countries

encourage the export of goods and services manufactured in their home market

or home country. ECAs assist manufacturers in their home countries to compete

57 Pure Cover is the official support provided by or on behalf of a government by way of export credit guarantee or insurance only. It is an ECA offer of protection against non-repayment by the buyer. Ex-Im Bank’s guarantees and insurance are both forms of pure cover. Guarantees typically imply 100 percent cover. Insurance applies a small risk -sharing deductible, which may increase under certain conditions. Source: Raquel Mazal Krauss, Institute of Brazilian Business and Public Management Issues, The Minerva Program, 2011. 58 Alasdair Whyte, Beginners guide to aircraft finance, February 20, 2017

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in the international market by providing export credit financing to buyers of these

goods on very competitive terms that are often times below market rate that is

difficult to be matched by commercial financing.

Second, export credit agencies provide financing to foreign buyers where private

sector financing is limited or where private banks or commercial lenders would be

reluctant or unwilling to provide the lending or assume 100 percent of the risk of

lending for those export sales.

Third, and perhaps their most important function is that, export credit agencies

assume risks beyond those that can be assumed by private banks or commercial

lenders. An ECA’s primary function is to shield the exporter from the political59

and commercial risks60 of selling overseas. This can be done as a supplier credit,

where the ECA guarantees the obligation of the importer on terms extended by

the exporter; or it can take the form of a buyer credit where the ECA supports the

obligation of the importer directly.61 The services of ECAs help to remove the risk

of uncertainty of exporting to other countries and underwrite political and

commercial risks of overseas investments. ECAs do not compete with private

financial institutions. To the contrary, they enhance the ability of their country’s

lenders to compete internationally. It should also be noted that they do not offer

development assistance to other countries; other agencies typically fulfil this role.

59 Political risks refer to those events that occur due to political actions taken by the government that impact payment by the buyer. These may include foreign exchange risks or transfer risk (inability to exchange the local deposit to that of the ECA country), expropriation, war risks, cancellation of an existing import and export license, and/or political violence. 60 Commercial risks refer to nonpayment as a result of bankruptcy, insolvency, protracted default, fluctuation in demand, unanticipated competition, shifts in tariffs, and/or failure to take up goods that have been shipped according to the supply contract and other factors not covered under political risks. 61 Raquel Mazal Krauss, Institute of Brazilian Business and Public Management Issues, The Minerva Program, 2011.

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The Home Market Rule

So with respect to aviation, the need for Export Credit Agency62 (ECA) financing

was to support and encourage aircraft manufacturing and assist aircraft

manufacturers in their home countries to export to countries where political risk

meant commercial bank loans were unavailable or not readily available. Along

the way there was this little known verbal understanding on which airlines can

access export credit guarantees between the US and the EU dating back to the

1980s, involving the US Export-Import Bank and its UK, French and German

counterparts that prevents support for purchases of Boeing and Airbus aircraft by

companies based in any of the four countries concerned, as well as Spain.

Although the Spanish ECA, Compañía Española de Crédito a la Exportación

(CESCE), does not actively participate in financing Airbus aircraft, the rule

extends to Spain due to the many Airbus manufacturing facilities located in

Spain.63 This understanding became the so-called "home market" or "home

country" rule.

The home market or home country rule is hardly a "rule" in the traditional sense,

but rather an unwritten, informal understanding64 between the US's Export-Import

bank - and its counterpart export credit agencies in the UK, France, Germany and

Spain65 that they will not offer export credit financing for competing aircraft of

airlines that will be principally located in their own or in each other’s countries.66 It

has been adhered to for many years by the various ECAs.67 No export credit

finance would be made available by ECAs to airlines established in the aircraft

62 For a full discussion of ECA financing as a method aircraft financing see this authour’s upcoming book on “International Aircraft Financing” 63 Dean N. Gerber, The 2011 Aircraft Sector Understanding: Calming the Turbulent Skies, The Air & Space Lawyer, Volume 24, Number 1, 2011 64 The fact that the status of this new ASU is a Gentlemen’s Agreement does not weaken this instrument. On the contrary, it could be stronger because it is the product of dialogue, conviction and trust. All the signatories got involved to pursue mutually beneficial fair-play and common interest. 65 The five countries represented by such ECAs are sometimes referred to as “Large Aircraft Countries” 66 David Knibb, In Focus: How new export credit rules will change aircraft finance, Flight Airline Business, January 22, 2013. 67 There were some limited exceptions e.g. Air France AF, KLM, Lufthansa and British Airways BA each had the option to finance two A380s supported by ECAs.

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producer States.68 The exact form, legal status and effects of the home country

rule remain clouded in mystery and are quite unclear. In particular, the rule has

never been published and it is unknown whether it is unofficially sanctioned by

the European Commission69 or the US government.70 The rule is unwritten and

not acknowledged due in part to concerns about possible claims of discriminatory

lending practices.

The consequence of the home market or home country rule is that no export

credit finance would be made available by ECAs to finance aircraft that are to be

operated by airlines established in producer States or controlled by airlines

established in producer States. U.S. and European airlines coped with this rule

for many years with little or no concern until the global financial crisis of 2007

which tightened availability of aircraft financing sources. The liquidity crisis

exposed the unfavourable consequences of the home market or home country

rule to the U.S. and European airlines. The funding costs associated with ECA

financing were generally perceived to be below market price and so airlines from

non-producer countries some of which were highly profitable such as the Middle

Eastern airlines were able to finance aircraft acquisition at relatively cheaper than

commercially available source of borrowing and at lower costs than their U.S. and

European counterparts. Again, the application of the home market or home

country rule was a concern. Because Canada did not subscribe to this rule, it

means that ECA financing would be available for financing of Bombardier C-

68 Producer States for these purposes are the United States, in respect of Boeing, and France, Germany, Spain and the United Kingdom, in respect of Airbus. 69 IAG, Response of the International Airlines Group to the European Commission’s request for consultation on a review of short-term export credit insurance, September 22, 2011. 70 While unwritten, the Ex-Im Bank Charter evidences that the U.S. Congress is well aware of the understanding. If one of the principal ECAs violates the Home-Country Rule in a manner that constitutes “non-competitive financing,” Congress may authorize the Ex-Im Bank to offer similar terms to U.S. sellers to match the terms of the offending ECA agency. 12 U.S.C. § 635a-3(a)(2)–(3) (2006). This statute also extends to ECAs located in other countries with significant aircraft manufacturing facilities, such as Canada and Brazil. Id.§ 635a-3(a)(1). Source: Dean N. Gerber, The 2011 Aircraft Sector Understanding: Calming the Turbulent Skies, The Air & Space Lawyer, Volume 24, Number 1, 2011

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Series aircraft but not to Airbus A320 and Boeing B737 family of aircraft even

though these aircraft are in the same market segment.71

Beneficiaries of export credit finance arrangements receive a two-fold benefit. On

the one hand, they receive capital that they would not otherwise have been able

on the commercial financial markets. On the other hand, because the guarantee

is State-backed and the ECAs and their guarantees enjoy AAA credit rating,

banks were more willing to provide loan/debt and with the reduced risk the debts

were able to price more competitively and at reduced servicing cost. The lower

loan servicing costs apply to very large aircraft such as the A380 where there is

very little appetite among traditional lenders to finance. These benefits reduced

the costs the aircraft and the airline would ordinarily incur in the normal course of

its business.72

Airlines in the USA and parts of Europe which did not qualify for export credit

because of the home market or home country rule complained that the rule

worked against them73 and gave some of their foreign competitor unfair

advantage. Their position was:

That the growth in the number of open skies agreements gave foreign

airlines greater access to US and European markets.

71 This concern was heightened when Bombardier’s announced plans to build the new 100-149 seat C-Series aircraft and the Canadian government decided to classify it as category 2 i.e. in the regional aircraft instead of category 1 where it rightly belongs due to its seat capacity and size. This state of affairs was very significant at the time because the new C-Series was then projected to enter service in 2013 and will be in the 100-plus seat narrow-body aircraft category, which had been dominated by the Airbus A320 and Boeing B737 families for a very long time.71 So if the Canadian government classify the C-series in category 2, Bombardier would have an unfair advantage in the marketplace because the aircraft would be subject to more favourable financing rules than either of its competitors71 who are in category 1 of the 2007 ASU and this may in turn negatively affect demand for A320 and B737 families of aircraft. 72 IAG, Response of the International Airlines Group to the European Commission’s request for consultation on a review of short-term export credit insurance, September 22, 2011. 73 The situation was particularly severe in the US and the Air Transport Association of America, now known as Airlines for America A4A, (the industry trade organisation for leading U.S airlines) representing a number of key ‘home operators’ sued the Ex-Im bank for providing a financing solution to Air India for its 787 deliveries which they argued provided an uneven playing field to a direct competitor.

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That cheaper financing available to foreign airlines through US Export-

Import Bank and its counterpart export credit agencies in the UK, France,

Germany and Spain not only enabled their foreign competitors to build-up

their fleets more effectively and efficiently74 but also created wholly artificial

incentives for the acquisition of new aircraft, flooding the global market for

passenger traffic with uneconomic capacity.

That the combination of these factors gave their strong rivals such as

Emirates and other foreign competitors’ unfair advantage that enabled

them to take market share causing significant income and job losses.75

.

Following this development a group of US and European airlines including Air

France, EasyJet, Lufthansa, Virgin Atlantic, American Airlines, Delta Airlines,

United Airlines, JetBlue and Southwest Airlines called on the OECD to form a

new understanding of official ECA support for aircraft to neutralize the perceived

advantages given to non-home-country airlines by virtue of their access to ECA

financing. Specifically, they called for a 20 percent cap on aircraft deliveries

financed with ECA-backed loans, higher export credit premiums and fees to be

charged by the ECAs in order to neutralise any interest rate advantage they yield,

lower maximum loan-to-value ratios and restrictions on ECA-backed loans to

airlines or lessors based in high-risk countries. One option open to the European

carriers to tackle this issue as a potential fall-back position is to get their

governments to impose protective duties on foreign carriers using subsidies or

74 So seriously was this that in August 2010, James May, President and CEO of the Air Transport Association of America (ATA) wrote to US Treasury Secretary Tim Geithner, noting that over the decade 2000-09, the US Export-Import Bank provided guarantees backing $45.7bn in financing for more than 800 large civil aircraft – more than the mainline fleets of every individual US airline. In financial year 2009 alone it made $8.6bn available to support sales of 143 aircraft to 17 foreign airlines and five leasing companies. Source: Martin Morris, Export credit guarantees, Special Reports, January 5, 2011. 75 The ATA estimates that subsidised aircraft financing by the Ex-Im Bank has added approximately 17 percent to the capacity of Ex-Im financed carriers on US international routes compared to the level these carriers would fly in the absence of such guarantees. As a result, foreign carriers with Ex-Im subsidised financing have taken market share from US airlines, reduced employment at US carriers by more than 6,000 jobs and caused income losses of over $500m annually, it claims. Source: Martin Morris, Export credit guarantees, Special Reports, January 5, 2011

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other forms of “non-commercial advantage” to undercut prices in line with EU

Regulation 868.

On the contrary, the ECAs benefiting airlines led by Emirates, Etihad and Ryanair

took the position that Export Credit Agencies are a legitimate and internationally

accepted financing support mechanism designed to boost manufacturing and

export of manufactured products and that these ECAs have assisted Boeing and

Airbus to sell their aircraft to airlines in far-flung markets that they may otherwise

not be able to reach. These airlines suggested changing or scraping the home

market or home country rule so that export credit would be equally available to all

airlines regardless of location as a way of addressing the concerns of the airlines

from the ECAs home countries.

The dispute over the role ECAs play in supporting sales of commercial aircraft

united rival manufacturers and pitted airlines and commercial banks against

governments. The reality is that the ECAs benefit both the foreign airlines and the

ECAs home markets and economies. Rather than wait for the US and EU air

carriers to lobby their governments to impose protective duties on foreign carriers

over this issue, a solution was found in the Aircraft Sector Understanding (ASU)

of 2011.

Aircraft Sector Understanding (ASU) 2011

There may be some merits in the argument that Export Credit Agencies support

and guarantees have certain unintended consequences that have caused some

market distortions in the way they have developed. For instance, in 2009, when

Delta Airlines and Dubai-based Emirates Air were each seeking financing for

three Boeing 777 aircraft, Emirates, through US Export-Import Bank support, was

able to obtain its financing at an interest rate of 3.47 percent, compared with 8.11

percent for Delta.76 A situation that enable foreign air carriers to access funds at

cheaper rates for their fleet through the ECAs than air carriers in the home

76 Martin Morris, Export credit guarantees, Special Reports, January 5, 2011

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countries of the ECAs would from the debt or commercial markets may amount to

subsidy in favour of the foreign air carriers.77

The 2011 ASU is a continuation of the concepts introduced by its predecessor,

the OECD’s 2007 Aircraft Sector Understanding and seeks to equalise

competitive financial conditions between participating states offering export credit

supported financing and also avoid distortion of competition between export

credit supported financing and other sources of financing.78 Another key

objectives of the 2011 ASU was to create a unified system of export credit

financing terms for all commercial aircraft types, in anticipation of new aircraft

types including Bombardier’s C-Series and the Mitsubishi Regional Jet.

The 2011 ASU79 which was adopted by the Organisation for Economic Co-

operation and Development (OECD) addressed most of the issues that prompted

the accord except to scrap the home market rule which provoked the loudest

arguments preceding the accord. This rule, which withheld export credit from US

and some European carriers, tilted the system, they claimed, in favour of rivals in

other countries who could and did take advantage of export credit.80 But the

OECD rejected the suggestion from Emirates and its allies to simply change or

scrap the home country rule and settled instead on higher export credit

premiums.

77 U.S. and European airlines viewed ECA financings as a form of subsidy for non-home-country airlines by either allowing non-home-country airlines access to advantageous financing terms that may not have been otherwise available to them in the commercial market or allowing creditworthy non-home-country airlines access to below market financing, in either case, putting U.S. and European airlines at a disadvantage by cutting into their market share with “subsidized” aircraft. Air Transport Association Calls on U.S. Government to Conclude New Aircraft Sector Understanding on Export Credits, The street (Dec. 16, 2010). 78 Aviation Working Group, Debt Capital Markets Financing of Aircraft Equipment, March 2016 79 ASU 2011 participating states and currencies: Australia, Brazil, Canada, the EU, Japan, Korea, New Zealand, Norway, Switzerland and the US. Eligible Currencies are Euro, Japanese Yen, Pounds Sterling, US Dollars and any other fully convertible currencies for which data is available to construct minimum interest rates using the 2011 ASU methodology. 80 David Knibb, In Focus: How new export credit rules will change aircraft finance, January 22, 2013, Flight Airline Business.

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What the 2011 Aircraft Sector Understanding Resolved

As a result, the 2011 ASU basically specified among other things that:

It eliminated the aircraft-type categorisation embodied in the 2007 ASU

and provided a system of common rules for all aircraft types.

All aircraft export credit deals must have a maximum of 12 year financing

and be priced based on eight risk factors.

It reduced the gap between ECA and commercial financing by raising the

exposure fee or export credit risk premium for all buyers/borrowers,

whether airline or lessor, but the rise is steeper for those with a better

credit rating.81 Higher-risk airlines will still pay more than but not as much

as airlines with better credit rating, making export credit less attractive to

airlines with better credit rating.82 The exposure fee charged on a particular

transaction reflects the creditworthiness of the borrower and/or guarantor

and the terms of the financing. The risk premium may be included in the

financed amount. This exposure fee or credit risk premium is to be charged

for each transaction in accordance with Appendix II of the 2011 ASU.

ECAs will also charge a commitment fee and other fees in accordance with

Article 16 of the 2011 ASU. The fees vary depending on whether the ECA

is providing a guarantee or a direct loan. Unlike the exposure fee or export

credit risk premium, the commitment fee and other fees cannot be financed

as part of the ECA financing.

81 The OECD agreed pricing structure is indeed designed to penalise strong credits 82 It is predicted that higher-risk airlines will continue to rely on export credit because they have nowhere else to go, but stronger airlines with access to commercial financing may find export credit less attractive and that such disincentives will drive financially strong airlines away from export credit and this is precisely the intended consequence and the underlying goal of the new ASU with the result, of course, that it will leave the ECAs exposed to higher risks.

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All aircraft export credit deals must have a maximum loan-to-value of 85%.

That means, ECAs may cover up to 85% of the aircraft net price for higher

risk airlines, but the cover for stronger airlines is limited to 80%.83

Regardless of credit risk rating of the airline, all ECA supported

transactions must be asset-backed, with protections for the lender and

ECA in the form of cross-default and cross-collateralisation of all aircraft

and engines owned by the same buyer/borrower, plus special creditor and

guarantor protections in the case of leased aircraft.84

Export credit for higher risk airlines may include higher initial security

deposits, shorter repayment periods, minimum lease payments for leased

aircraft and higher maintenance reserves.85

ECAs will support the financing of “used” aircraft on a case-by-case basis

subject to the terms and conditions set forth in paragraphs 18 and 19 of

Part 3 Used Aircraft, Spare Parts, Maintenance and Service Contracts of

the 2011 ASU.

The 2011 ASU also provided that the airlines of any country that adopts

the Cape Town Convention, making it their national law, qualify for a

discount of up to 10% on their export credit premium.86

The discount is only available where the relevant contracting state has made all

of the qualifying declarations, including the adoption of the CTC Alternative ”A” 83 This is another feature designed to make ECA financing less desirable for these buyers/borrowers who can more readily access commercial financing. 84 David Knibb, In Focus: How new export credit rules will change aircraft finance, Flight Airline Business, January 22, 2013. 85 This requirement is intended to reduce credit risk. 86 The rationale of this is to encourage nations to adopt the Convention on International Interests in Mobile Equipment and its related Aircraft Protocol, collectively called the Cape Town Convention. This carefully crafted law creates an international registry of security interests in aircraft and spells out creditor rights, thereby eliminating much of the uncertainty about how creditors might fare in a local jurisdiction after an air carrier's default or insolvency. The so-called "Cape Town discount" no doubt gives airlines in the countries adopting the Cape Town Convention an added incentive. For instance, the then Australia's transport minister Anthony Albanese estimates that adopting the convention will save Australian airlines, which routinely use export credit, $330,000 on a new ATR 72 turboprop and $2.5 million on an Airbus A380.

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insolvency regime, and has effectively implemented the Cape Town Convention

in such a way that its Cape Town Convention commitments are appropriately

translated into national law. The Aviation Working Group reported that a system

is being developed under the University of Oxford – University of Washington

Cape Town Convention Academic Project that contemplates compliance

reporting on a public database.87

The OECD is the body responsible for determining whether a contracting state

has fulfilled the conditions for the ‘Cape Town Discount’ and whether a

contracting state ceases to meet such conditions. Where a contracting state has

ceased to comply with its Cape Town Convention and qualifying declaration

commitments, the OECD may determine that such contracting state is no longer

eligible for the ‘Cape Town Discount’. This means that the incentive provided

under the 2011 ASU is not limited to effective implementation but extends to

continuing compliance with Cape Town Convention commitments. Sanctions for

non-compliance with the Cape Town Convention include: loss of the ‘Cape Town

Discount’; reputational costs in aviation, legal and investment sectors; and the

resulting upward revision of risk and financing rates.88

This 2011 ASU rule applies to new aircraft from all manufacturers except those in

China and Russia, which are not OECD members. Brazil is not an OECD

member either but accepted the new ASU. The 2011 accord attempted to bring

ECA financings more in line with market conditions and by including new aircraft

from Canada, Brazil and Japan, the 2011 ASU will also have the effect of

minimizing the support of the ECAs as a factor in the choice by buyers/borrowers

among competing aircraft. It is hoped that the participating states of this accord

group is expanded to included China and Russia and other potential aircraft

manufacturing countries in order to have a worldwide effect.

87 Aviation Working Group, Debt Capital Markets Financing of Aircraft Equipment, March 2016 88 Aviation Working Group, Debt Capital Markets Financing of Aircraft Equipment, March 2016

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For a long time, the financing of aircraft orders was aided by government owned

or quasi government export credit agencies. These sources of aircraft financing

became popular following the 2007-2008 financial crisis, as they allowed access

to relatively cheap finance at a time when bank lending was scarce.89 But the

introduction of revised minimum premium rates under the OECD’s 2011 Aircraft

Sector Understanding 90 has increased the cost of export credit agency supported

financing for a number of airlines and operating lessors. As a result, these loans

have become less popular as the prescribed terms as set out in Aircraft Sector

Understanding, 2011 have become less competitive in comparison to other

sources of funding.91

The 2011 ASU is a complex agreement whose essential aim was to make the

use of government controlled export credit agencies less attractive. It is no

“magic wand”, but it is a legitimate instrument to prevent and defuse trade

conflicts in a very contested and crucial sector, a new safety net against

transaction based disputes.92 Export credit volume has now reached an all-time

low in 2016 and 2017, due in part to the OECD’s 2011 Aircraft Sector

Understanding,93 the healthy commercial liquidity resulting from influx of money

from virtually every kind of source94 and in part to separate, unrelated

interruptions to official export credit support for Boeing and Airbus aircraft.

89 EY, Aviation finance: an interesting prospect for long-term investors, April 2017 90 The 2011 ASU is a continuation of the concepts introduced by its predecessor, the OECD’s 2007 Aircraft Sector Understanding and seeks to equalise competitive financial conditions between participating states offering export credit supported financing and also avoid distortion of competition between export credit supported financing and other sources of financing. 91 Dragana Timotijevic, Aviation Leasing As Part of a Broader Investment Portfolio for INVESTEC AVIATION FINANCE 92 Remarks by Angel Gurría, OECD Secretary-General, during the Signing Ceremony of the 2007 “Aircraft Sector Understanding on Export Credits for Civil Aircraft” in Rio de Janeiro, Brazil, 30 July 2007. 93 The introduction of revised minimum premium rates under the OECD’s 2011 Aircraft Sector Understanding has increased the cost of export credit agency supported financing making less attractive as an aircraft financing source and it is making airlines to look for other sources for their financing requirements. 94 Such as from places like Korea, Australia and the Japanese regional banks as well as from Taiwan and Chinese commercial markets.