Vedder Thinking | Articles The Evolving Paradigm of Aircraft ABS and the Purchase of E-Notes by Third Parties
Historically, aircraft asset-backed securitizations (ABS) have provided operating lessors the opportunity to finance large portfolios of commercial aircraft with very attractive debt pricing. In these transactions, an operating lessor typically sells a large portfolio of aircraft to a bankruptcy remote special purpose vehicle (the Issuer), with the Issuer financing the purchase of the aircraft portfolio with the issuance of (i) investment-grade rated bonds in a capital markets offering1 and (ii) E-notes to the party taking the residual risk in the underlying aircraft assets, which has oftentimes been the sponsoring operating lessor. The Issuer in turn contracts with a servicer that is recognized and experienced in the management and remarketing of aircraft assets (the Servicer) (typically the sponsoring operating lessor) to provide aircraft and lease management and remarketing services for the aircraft portfolio. Subject to a limited universe of actions that require Issuer board approval, the day-to-day decision making regarding the aircraft portfolio is managed exclusively by the Servicer. The Servicer's experience and reputation in the successful and active management of aircraft assets, and the fact that the Servicer has broad and exclusive lease management and remarketing rights, are key components of both the rating agencies' issuance of an investment-grade debt rating and the bond investor's decision to purchase the bonds. Accordingly, this strong Servicer role is an integral part of ABS technology.
The resurgence of aircraft ABS over the course of the past three years has led many operating lessors to utilize ABS technology as a means to dispose of a portfolio of aircraft by selling the E-notes (an Equity Disposition ABS), rather than merely financing the portfolio and retaining the E-notes, and residual risk, for its own account. While the E-notes are intended to provide the investors the economic equivalent of an equity return and typically afford the investors the right to elect the directors of the Issuer, they are not generally structured to provide the investors the same control rights that the owner of a portfolio of aircraft would typically enjoy in a non-ABS structure, as these control rights have traditionally resided with the Servicer as part of the ABS technology. Because the sponsoring operating lessor has typically filled the Servicer role and also retained any E-notes (or related entities with the same economic interests filled both roles), the E-note holder has had little incentive to evaluate or question its level of control. The increased incidence of Equity Disposition ABS transactions has thus created an inherent tension between the E-note investors and the sponsoring operating lessor Servicer as E-note investors have, with varying degrees of success, begun to seek increased control rights in certain circumstances that would otherwise be more consistent with traditional equity investor roles. The purpose of this article is to explore some of the areas in which E-note investors have sought to have more control over aircraft portfolio decisions.
Control Rights—Traditional ABS Technology
In an ABS transaction in which the operating lessor retains the equity and services the portfolio (a Sponsor/Servicer ABS), the Servicer generally can manage the portfolio without input from the Issuer other than with respect to:
- asset dispositions;
- entering into leases that do not contain core lease provisions;
- entering into leases that would result in a breach of concentration limits;
- approval of the annual budget and capital expenditures outside of the approved budget;
- entering into certain affiliated transactions; and
- committing to acquire assets.
The intent is that the Servicer is given broad authority to manage the portfolio. In a Sponsor/Servicer ABS these provisions have become fairly standard and are not subject to negotiation inasmuch as the Sponsor controls both the Issuer and the Servicer in a Sponsor/Servicer ABS.
Control Rights—Equity Disposition ABS
In recent Equity Disposition ABS transactions, the E-note investors have sought to have more input into the asset management decisions that otherwise would be decided independently by the Servicer under traditional ABS technology. The means and level of input that E-note investors have exerted have been colored by many factors. Single E-note investors that purchased 100 percent of the issued E-notes have sought more control than syndicate investors in E-notes. E-note investors in transactions involving portfolios with older aircraft, and/or shorter remaining lease terms where the need for active management was more likely, have sought more control than E-note investors of more "stable" portfolios (i.e., newer aircraft and/or longer remaining lease terms). Finally, E-note investors with prior experience in principal aircraft (metal) investing and/or aircraft servicing experience have sought more control than financial investors.
The main areas in which the E-note investors have sought to participate in decisions include:
- lease rates and economics;
- substitution of engines in lieu of paying maintenance reserve disbursements;
- significant capital expenditures;
- lease-end adjustments and buyout of return conditions;
- transactions between the Servicer and Issuer (i.e., conflict of interest management);
- early lease terminations; and
- timing of lease default enforcement.
While the success achieved by E-note investors that have sought increased rights has varied significantly, it is safe to say that in all instances the balance of decision making authority with regard to the day-to-day management of the aircraft portfolio has continued to rest with the Servicer, even in Equity Disposition ABS transactions. This is understandable given that the Servicer tends to have significant concerns regarding broader issues that are external to the ABS, including market reputation, lessee relationships and nondiscrimination obligations to other customers that use the Servicer to service portfolios.
Standard of Care
Given the broad portfolio management powers afforded a Servicer in an ABS transaction, the servicing agreement imposes a "Standard of Care" that the Servicer must live up to in the performance of the services. The Standard of Care imposed in Sponsor/Servicer ABS transactions generally has contained two components: (i) a general standard of care tied to industry standards and (ii) a more specific standard of care tied to what the Servicer does with its own assets. An example of this Standard of Care is set forth below:
"Standard of Care" means reasonable care and diligence at all times consistent with the reasonable commercial practice of a prudent international aircraft lessor involved in the management, servicing and marketing of commercial jet aircraft and related assets, but in any case no less reasonable care and diligence than it would use with respect to the other aircraft that are owned by the Servicer directly or indirectly.
In certain recent Equity Disposition ABS transactions, the Standard of Care has included only the first component, particularly where the Issuer was successful in negotiating increased control rights in circumstances in which the Issuer could direct the Servicer to take actions that the Servicer would not take with respect to its own aircraft. An example of such a Standard of Care is set forth below:
"Standard of Care" means reasonable care and diligence at all times consistent with the reasonable commercial practice of a prudent international aircraft lessor involved in the management, servicing and marketing of commercial jet aircraft and related assets, but subject to any directions given by the Issuer in accordance with this Agreement.
The takeaway here is that, to the extent the Servicer is willing to allow the Issuer increased rights in an Equity Disposition ABS, the Standard of Care may be adjusted to reflect these increased Issuer rights.
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While there have not been a sufficient number of Equity Disposition ABS completed such that standard market practice has developed regarding control rights in Equity Disposition ABS, it is clear that there has been a paradigm shift in the negotiations and documentation as E-note investors seek to assert more control over aircraft portfolio investment decisions. Rather than a standard market practice developing, the ways in which E-note investors seek to have additional control over portfolio management will likely develop on a bespoke basis driven by the nature of the portfolio that is being managed, the identity and interests of the E-note investors and the E-note investors' prior experience in aircraft investing and servicing. Regardless of these developments, the Servicer will continue to play the primary role in portfolio management decisions in ABS.
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1 This is typically a multitranche debt offering, which often includes a non-investment grade tranche.