Donald G Gray and Auriol Marasco, Blake Cassels & Graydon LLP
How is it that US major airlines with poor corporate ratings or, in the case of American Airlines, while in bankruptcy, can issue investment-grade debt to finance their aircraft fleets? That is the “magic” of the US Enhanced Equipment Trust Certificate (EETC) structure. In early 2013, American Airlines issued $700 million of debt while in bankruptcy at rates of 4 per cent and 5.625 per cent to finance 13 new and used airliners. That was the latest in a long line of US airline EETCs which have provided billions of dollars of very low-cost asset-based financing for new and used aircraft over the past 20 years.
In 1999/2000, Air France and Iberia were the first non-US airlines that tried to tap this market but, because of legal uncertainties, particularly in respect of enforcement against airlines in bankruptcy under French and Spanish law, their transactions, while structurally similar to US airline EETCs, were significantly more expensive than the US transactions and were therefore not repeated.
How then was Air Canada, in May 2013, able to finance C$1 billion worth of new Boeing 777-300ERs at a blended rate of 4.66 per cent, which is, by a large margin, the lowest cost financing that Air Canada has ever obtained for its aircraft and a rate highly competitive with EETC rates for US airlines?
The story of Air Canada’s historic and precedent-setting EETC is really the confluence of two separate but equally interesting and important stories: first, how EETCs have revolutionised the financing of aircraft for major US airlines and, second, how the Cape Town Convention, if implemented properly in applicable countries, can and will deliver major financial benefits to the world’s airlines.
EETCs are US capital markets products that really use legal structuring to create “something out of (what might appear at first look to be) nothing” (or, perhaps more accurately, “something much more out of much less”). The EETC structure has used a combination of legal and financial enhancements to create investment-grade debt issues from US airlines which generally have corporate ratings that are well below investment grade.
Each EETC Certificate represents an interest in a pass through trust. Funds raised in relation to the offering are used by the trusts to acquire equipment notes. These equipment notes are in turn used to acquire the aircraft, which are used as security for the equipment notes. In the case of the Air Canada offering, a special purpose vehicle was established to acquire title to the aircraft and to conditionally sell the aircraft to the airline. The installment payments under each conditional sale agreement are passed on to investors as interest and principal on the certificates.
EETC offerings are divided into different classes with differing profiles. Senior ranking certificates hold a higher position in the distribution of proceeds and, consequently, receive a lower rate of return than lower-ranking, higher risk certificate classes. Air Canada’s EETC offering included Class A, Class B and Class C certificates.
Legal/structural enhancements that are used to provide the required corporate ratings upgrades for EETCs include:
structural enhancements to provide improved loan-to-value (LTV) ratios for the more senior tranches; and
a liquidity facility from an independent highly rated bank or banks to provide up to 18 months (for US Airlines and, now, Air Canada, as well as, most recently, British Airways) to be used in the event of any missed interest payments for senior-rated EETC certificates.
An EETC transaction is essentially a single corporate credit aircraft mortgage/lease securitisation, with a security interest in the aircraft enabling a very high recovery rate if the airline defaults. EETC certificate holders have received almost 100 per cent recovery in the various US airline bankruptcies.
What is now the Cape Town Convention began in 1988 as a suggestion from Professor Ronald Cummings, of the University of Saskatchewan, to his colleague, Professor Sir Roy Goode of Oxford University, who were working together on the UNIDROIT Conventions on Financial Leasing and Factoring. The initial idea was to replace the lex situs rule with the “location of the debtor” rule, which is obviously far more practical for mobile assets operating in multiple jurisdictions. The idea was submitted in concept to UNIDROIT for consideration as a future project. UNIDROIT liked the idea but lacked the resources to move it ahead. UNIDROIT, therefore, told the aviation industry that if the industry provided the resources to prepare the treaty it could be done under UNIDROIT auspices. Accordingly, in 1994, the Aviation Working Group (AWG) was formed by Boeing and Airbus under the leadership of Jeffrey Wool, to provide the logistical support necessary to prepare and submit a treaty that would be acceptable to financiers and operators of high-value mobile equipment.
The project quickly expanded to include the concept of an international registry for registrations of security interests (and searches) against aircraft and aircraft engines, and uniformity of certain basic remedies for enforcement. Notably, it also included the internationalisation of Section 1110 (known as Alternative A in the treaty) which had long benefited US airlines, providing them with a distinct advantage in their efforts to finance and refinance and access capital, particularly during times of financial stress. Moody’s had historically given a one-notch upgrade over unsecured ratings to Section 1110-protected transactions. After certain amendments in 1994 to strengthen its provisions, the Section 1110 upgrade moved to two notches.
Early on, the AWG realised the value of bringing the airline industry, as represented by IATA, on board with the project. Analysis by more sophisticated airline borrowers indicated that the treaty’s enhancement of predictable and timely enforcement against aircraft assets would reward airlines with greater availability and lower costs of financing for their aircraft. Air Canada, through David Shapiro, then senior aircraft financing counsel at Air Canada, was one of the first major international airlines to recognise the inherent value of this treaty. Mr Shapiro spoke on behalf of IATA at the Montreal session affirming why such a treaty would be critically important to the airline industry in future. Air Canada recognised that many of the low-cost financings available to its US counterparts were largely driven by the benefits of Section 1110, placing all other airlines at a competitive disadvantage. In 2002, with strong Air Canada support, IATA, in its Annual Report stated:
This [Cape Town] achievement crowns many years of effort by IATA... the benefits should be felt soon. Those benefits are: reduced risk of credit financing and therefore diminished costs of financing aircraft, greater access to financing... and improved ability to dispose of used aircraft.
Alternative A was designed to be an enhanced version of Section 1110. Specifically, Alternative A does not include some of the qualifying issues faced for Section 1110 benefits in the US and also requires, as a condition for the continuing stay, that: (i) the aircraft be maintained pursuant to the requirements of the applicable contract during the stay period; and (ii) the value of the aircraft be preserved during the stay period.
CTC in Canada
The Canadian delegation to the UNIDROIT sessions was second only to the US delegation in its active participation in and support for the treaty preparation process. Canadian delegates were members of the various treaty drafting groups and the author chaired the Insolvency Sub-Group that prepared Alternative A.
On 1 April 2013, Canada ratified Cape Town, a step more than a decade in the making. After it provided its formal signature to the Convention on 31 March 2004, Canada’s progress towards ratification was slow. On 24 February 2005, the federal government enacted, but did not fully proclaim, the International Interests in Mobile Equipment (aircraft equipment) Act (Canada) (the CTC Act). The CTC Act is the federal implementing legislation for the Convention; a necessary requirement, along with similar provincial and territorial implementing legislation, to make Cape Town law in Canada. On 28 September 2005, in an effort to rectify this disadvantage caused by the failure to fully ratify Cape Town, Canada amended its insolvency legislation by proclaiming in force those parts of the CTC Act which essentially mirrored Section 1110 and Alternative A.
On 22 January 2008, Canadian aviation industry representatives, certain financiers of Canadian airlines (including Boeing) and the US Export-Import Bank met with the federal and provincial governments to discuss the further implementation of the Convention. The federal government offered the aviation industry two choices: proclaim the Convention in force immediately without the preferred treaty declarations, including Alternative A, or wait to proclaim the Convention into force until such time as existing legislation could be amended to accommodate those declarations. The Canadian aviation industry representatives unanimously selected the latter course of action. Accordingly, over the next five years and several meetings with industry representatives, the federal government began to amend the potentially conflicting statutes which would allow the federal government and the various provinces and territories to fully proclaim the CTC Act and ratify Cape Town in Canada. It also amended the CTC Act to exclude certain public law issues, such as UN obligations and terrorism sanctions, from the primacy of Cape Town. On 21 December 2012, Canada deposited its signatures for ratification with UNIDROIT and, simultaneously, fully proclaimed the CTC Act, finally giving Canadian airlines access to the full benefits of Cape Town effective on 1 April 2013.
Air Canada EETC 2013
In 2004, S&P in New York was approached about the possibility of rating an Air Canada EETC for Air Canada’s upcoming Boeing 777 deliveries, but were advised that, because of the unavailability of Section 1110 in Canada and because a “hostile” stay against aircraft creditors could, in theory (although an extremely remote risk in practice), extend indefinitely under Canadian bankruptcy law, the costs of such a transaction, including a long liquidity facility and/or repossession facility, would be uncompetitive and in excess of the costs paid by Air Canada’s US competitors. So, for the time being, the project was shelved.
With the pending Canadian ratification of Cape Town referred to above, and Air Canada’s next wave of scheduled Boeing 777 and 787 deliveries coming, all three of the major US rating agencies were again approached in 2011 and 2012, as were all six of the major US EETC banks, with a favourable update of Canadian law as supplemented by Cape Town with all of the OECD ASU “qualifying declarations”. In autumn 2012, Air Canada decided to conduct an RFP process for the EETC banks. Shortly thereafter, Morgan Stanley and Credit Suisse were selected to co-lead and manage the transaction. Citi and Deutsche Bank were subsequently added as bookrunners. After a separate RFP process, Natixis was selected as liquidity facility provider.
Air Canada elected to have the transaction rated by all three rating agencies and received excellent results.
Key to the transaction’s success was the nature of Canada’s legal system and the form in which it has adopted Cape Town and Alternative A. Cape Town as adopted in Canada was deemed by the rating agencies as the functional equivalent of Section 1110 in the US. Particular points highlighted by the agencies included the fact that the Canadian legislation explicitly states that the treaty supersedes all existing laws (with certain narrow exceptions) and even goes further than Section 1110 in protecting creditors by explicitly obliging a Canadian airline and the Canadian government to assist creditors in the deregistration and export of the aircraft and requiring the airline to preserve the aircraft and its value in accordance with the financing agreement during the 60-day stay period.
These points allowed the rating agencies to unanimously give Cape Town (as implemented in Canada) equal notching benefit to that given to Section 1110 in the US from a legal enforceability aspect. Consequently, Air Canada’s EETC was able to be on par with those of the US carriers from a structural perspective, without the need for any additional enhancements (such as a 24-month liquidity facility as required in the Doric/Emirates EETC transaction in 2012).
Air Canada’s high quality collateral, the five Boeing 777-300ERs financed for only the second time through an EETC, and its effective capital structure which employed three tranches of debt with initial LTVs of 48.9 per cent, 69.5 per cent and 82.3 per cent, allowed the company to achieve historic notching uplift from the rating agencies without sacrificing duration or total proceeds raised. Moody’s, S&P and Fitch each gave the transaction their highest notching benefits for the A Tranche, +7/+9/+9 (M/S/F), giving the Class A certificates three investment grade ratings and an NAIC 1 designation.
Cape Town in Canada, plus the EETC structure, delivered outstanding results for Air Canada, and bodes well for the future financing requirements of major airlines in Canada. It also sets a precedent for tangibly demonstrating the potential and benefits to be achieved by proper implementation of Cape Town by other jurisdictions.
This is a revised version of an article co-authored with David J Shapiro, senior vice president and chief Legal Officer, Air Canada for the July/August issue of Canadian Equipment Finance.