November 25, 2014

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November 25, 2014

November 24, 2014

Priority of Ownership and Security Interests in a Repossession Scenario

One of the key components to any aircraft leasing or financing arrangement is the ability of the lessor or financier, as applicable, to repossess the aircraft if the lessee or borrower defaults. A lessor’s or financier’s ability to repossess an aircraft may be impeded if (i) the relevant obligor has transferred possession of, or rights in, the aircraft to a third party pursuant to a lease, sublease or other arrangement and such third party claims a superior right to the aircraft, or (ii) a party that has performed maintenance on the aircraft has not been paid and asserts a lien on the aircraft. PNCEF, LLC v. South Aviation, Inc.1 (the PNCEF Case) is a recent case that illustrates how lessors and financiers may mitigate these risks through the use of clear contractual provisions that (i) require subordination arrangements in the case of third party possessory or other rights, (ii) restrict the ability of lessees to assert mechanics liens against an aircraft, and (iii) require lessees to clear mechanics liens asserted by third-party maintenance providers.

Facts of the Case

The PNCEF Case involved the purchase of four business jets by affiliated buyers (each, a Borrower, and collectively, the Borrowers). Each Borrower financed the purchase of its aircraft with a loan from PNCEF, LLC (the Lender) and granted the Lender a security interest in its aircraft pursuant to a mortgage agreement. Under each mortgage agreement, the Lender was entitled to immediate possession of the relevant aircraft if (i) the Borrower defaulted under the related financing arrangement and (ii) the Lender requested the Borrower to return such aircraft. Subsequent to purchase, each Borrower leased its aircraft to South Aviation, Inc. (the Lessee) pursuant to a lease agreement. Each lease agreement provided that:

  • the Lessee’s rights thereunder were “at all times, even when no event of default exists [under the related lease agreement], subject and subordinate to the rights of [the Lender] in and to the Aircraft”; and

  • the Lessee was expressly prohibited from (i) creating any liens on the aircraft or (ii) allowing any liens to be placed on the aircraft, except for inchoate workmen’s, repairmen’s or similar liens that had to be cleared by the Lessee.

After taking delivery of the aircraft under the lease agreements, the Lessee performed maintenance on the aircraft2 and subsequently filed mechanics' liens against each aircraft. Subsequently, each Borrower defaulted under the financing arrangements, causing the Lender to invoke its right to immediate possession of the aircraft. In turn, the Borrowers attempted to procure the return of the aircraft from the Lessee, which refused the Borrowers’ requests on the basis that the liens that the Lessee had filed against the aircraft were superior to those of the Lender. In response, the Lender sued the Lessee requesting the court to enter an order requiring the Lessee to return the aircraft to the Lender. The court denied this request, and the Lender appealed the ruling.

Court’s Analysis

The appellate court reversed, concluding that the Lender was entitled to possession of the aircraft. In reaching this conclusion, the appellate court determined that each Borrower and the Lessee had expressly provided in its lease agreement that the Lessee’s quiet enjoyment rights were subordinate to the Lender’s rights in the aircraft. Consequently, the appellate court concluded that the Lessee had waived any priority that its liens may have otherwise had. In its waiver analysis, the appellate court determined that (i) the Lessee’s rights under the lease agreements were waivable, (ii) the Lessee had actual or constructive knowledge of such rights and (iii) the Lessee had intended to relinquish such rights. In addition to its ruling with respect to the subordination language, the appellate court determined that the right to create any liens on the aircraft had also been waived by the Lessee pursuant to the provision expressly prohibiting the Lessee from filing liens against the aircraft. As such, the appellate court ruled that the Lender’s rights ranked higher in priority than those of the Lessee and that the Lender was entitled to possession of the aircraft.

Conclusions

Subordination Language

The PNCEF Case serves as a reminder to lessors and financiers (each, a Superior Party) of the benefits of including covenants in lease and financing agreements (each, a Superior Agreement) that require lessees and borrowers to obtain express subordination undertakings in connection with subleases, leases or other third party arrangements (each, a Subordinate Agreement) pursuant to which a lessee or borrower transfers possession of an aircraft to a third party (a Subordinate Party). In the event any Subordinate Party attempts to impede (i) the Superior Party from exercising any of its rights against the lessee or the borrower or (ii) the lessee or borrower from fulfilling any obligation it may have to the Superior Party, carefully drafted subordination undertakings will protect the Superior Party’s priority and ability to repossess and foreclose. Financiers and lessors should ensure that the subordination covenants require each Subordinate Agreement to have clear subordination undertakings that address the points set forth below.

  • Identify the Agreements: The Superior Agreement and the Subordinate Agreement should be clearly identified, and it should be noted that the rights of the Subordinate Party under the Subordinate Agreement are subject and subordinate to the rights of the Superior Party under the Superior Agreement.

  • Specific Language: The priority of interests, rights and/or claims and any alteration to the priority ranking that would otherwise exist as a matter of law absent such a provision should be clearly delineated.

  • Eliminate Qualifications: If the subordination undertakings are intended to apply notwithstanding the fact that the Subordinate Party may not be in default under the terms and conditions of any such Subordinate Agreement, the subordination provision should clearly state so.

  • Direct Enforcement Rights: The Superior Party should be granted the ability to directly enforce its rights against the Subordinate Party. This can be accomplished through (i) an assignment to the Superior Party of the rights of the borrower or lessee, as applicable, in the Subordinated Agreement or (ii) a letter addressed to the Superior Party from the Subordinate Party or an express provision in the Subordinate Agreement (that the Superior Party is made an express third party beneficiary of), whereby the Subordinate Party agrees to the subordination and grants the Superior Party the right to exercise any rights it might have under the Superior Agreement or that the borrower or lessee may have under the Subordinate Agreement against the collateral.

In addition, parties involved in multi-tier lease structures or other structures where a Subordinate Agreement may be entered into simultaneously with, or prior to, a Superior Agreement, should ensure that the Subordinate Agreement contains subordination provisions consistent with that described above, or obtain stand-alone subordination undertakings from the Subordinate Party, at the outset of the transaction. For example, in the case of a multi-tier lease structure, such subordination provisions will ensure that the relevant sublease remains in effect only so long as the head lease remains in effect and subjects the sublessee’s rights to the termination provisions in the head lease.

Mechanics' Liens

Because the appellate court in the PNCEF Case concluded that the Lessee had waived any right it had to assert a superior lien based on the express language in the lease agreements, the court never addressed whether the Lessee would have had a valid superior lien on the aircraft absent the express language contained in the leases. Accordingly, the PNCEF Case leaves open the possibility that, in a lease arrangement where (i) the lessee is permitted or required to perform maintenance and is entitled to some form of payment or reimbursement for such maintenance and (ii) the lessee is not prohibited from placing a lien on the aircraft for the cost of maintenance, the lessee could perform maintenance on the aircraft and assert a mechanics' lien on the aircraft to secure payment for such performed maintenance. Given that certain possessory liens are afforded statutory priority over other security interests in the same collateral, there is risk that a lessee in default could assert its rights under such a lien to prevent a financier or lessor from exercising its repossession rights.

In light of this implication and more generally to reduce the risk that a third party maintenance provider will be in a position to assert a valid mechanics' lien on a financed or leased aircraft, financiers and lessors should ensure that leases contain clear provisions that (i) prohibit a lessee from creating liens or (ii) prohibit or restrict the ability of a lessee to assert a claim against the lessor for cost of maintenance. Without such language, a financier or lessor could find itself in a situation in which it has to pay its lessee or third party to release a possessory lien before the financier or lessor can regain possession of, and begin to collect any proceeds generated from, the repossessed collateral.


1 60 So. 3d 1120 (Fla. Dist. Ct. App.) (May 11, 2011).

2 It is not clear from the court’s decision or the briefs filed in the case whether the Lessee was required to perform such maintenance under the lease agreements. The appellee’s brief noted that “[the Lessee] had invested a substantial sum of money in the subject aircraft in the form of repairs and maintenance, including parts and labor… In order to compensate [the Lessee] for its investment in the respective aircraft [the Lessee] was afforded a reduced monthly rental.” Appellee Answer Br., PNCEF, LLC v. South Aviation, Inc., No. 4D10-2860, 2010 FL App. Ct. Briefs LEXIS 394, at 3 (4th Dist. Sept. 3, 2010).

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About this Author

Adam R. Beringer, Vedder Price Law Firm, Finance Attorney
Shareholder

Adam R. Beringer is a Shareholder at Vedder Price and a member of the firm’s Global Transportation Finance team. With a practice focused on commercial aviation finance, Mr. Beringer acts on behalf of equity and debt participants in a wide variety of aircraft leasing and finance transactions, including operating leases, leveraged leases, mortgage financings, structured financings and purchase and sale transactions. In particular, Mr. Beringer has significant experience representing operating lessors, commercial banks, private equity funds, hedge funds and other aircraft investors in M...

312-609 7625
Christopher J. Shalvoy, Finance, Attorney, Vedder Price, Law Firm
Associate

Christopher J. Shalvoy is an Associate at Vedder Price and a member of the firm's Global Transportation Finance team. He focuses his practice on aircraft and railcar financings.

312-609-7635