Aviation Finance: what are the key features of a finance lease?

In aviation finance, there are a variety of leasing arrangements from which parties may choose to best structure their transactions. This article summarises the key features of one such type of leasing arrangement: the finance lease.

What is a finance lease?

A finance lease is a form of leasing arrangement. As with its operating lease cousin (which we discuss here), a finance lease sets out the arrangement by which the owner of the aircraft (the Lessor) agrees to grant to the lessee (the Lessee) the use of the aircraft for a prescribed period of time in consideration for the payment of rent with the intent that the Lessee becomes the legal owner of the aircraft at lease termination; the Lessee is deemed the "economic owner" of the aircraft during the term of the finance lease.

Unlike in operating leases, where the rental paid to the Lessor is for the Lessee's use and possession of the aircraft and is set with reference to broadly commercially set market influenced rental rates linked to the period of use, the amount of rent paid under a finance lease is calculated to "track" the expenditure by the Lessor vis-a-vis its purchase of the aircraft. The Lessor's purchase of the aircraft in a financing leasing structure will typically have been funded through debt with the intention that all rental payments made during the course of the lease term of the aircraft is sufficient to fully amortise the cost to the Lessor of purchasing the aircraft. We explain this further below.

When is a finance lease used?

A finance lease will typically be entered into as a means by which a Lessee is able to finance its acquisition of an aircraft. The economic effect of finance leases on a Lessee can be said to be similar to that of a secured lending, tax implications aside.

What are the key features of a finance lease?

Structure

In financing leases, the Lessor/owner will typically be a special purpose vehicle (an SPV). Depending on the level of sophistication of the proposed financing, either the Lessee will have ultimate control of the SPV or the SPV will be "off balance sheet" and insolvency remote, meaning its shares are not held by the Lessee but by way of an orphan trust structure. These latter types of SPVs will be incorporated by either the financing bank or by the Lessee.

The SPV in a finance lease transaction will also be the borrower in the underlying secured lending. As a basic illustration, the financing and the leasing of the aircraft will be as follows:

1. the SPV as borrower will enter into a facility agreement to borrow funds for the purpose of acquiring the aircraft;

2. the facility agreement will set out the loan repayments and interest payments that the SPV is required to make to its lenders; and

3. the SPV as Lessor and the Lessee will enter into a finance lease pursuant to which the Lessee undertakes to pay the Lessor rental amounts which will be sufficient for the SPV to meet its payment obligations under the facility agreement.

Flexibility

One key advantage of an operating lease, outlined in our earlier article, "Aviation Finance: What are the key features of an operating lease" is that it provides a high level of flexibility for the Lessee. An operating lease enables the Lessee to keep a diversification in its fleet and allows for easier substitution or replacement of aircraft, if for example the Lessee/airline foresees use of that kind of aircraft for only a (relatively) short period of time. It also makes it easier for the Lessee to upgrade its aircraft.

Under a finance lease, this flexibility for the Lessee does not exist as finance leases will be aligned with the underlying financing that is in place, which in turn will typically be aligned with the lifespan of the asset. This means the (SPV) Lessor in a finance lease will not be able to, nor will it be its intent, to monetise its asset to the full extent possible, which a lessor could do if enabled by a series of shorter term operating leases over the relatively long life of the asset.

Whilst flexibility may not be a key benefit for an airline under a finance lease, it can be said to be one for lenders. An issue that lenders may have in the aviation sector if they were to enter into traditional secured lending model is that the security granted to them for an airline's loan obligations under a facility agreement would be primarily that of the aircraft mortgage. However, there are certain challenges associated with this including:

1. a lack of certainty as to whether one country's courts will necessarily enforce the mortgage of another country (this is a key concern for lenders whose main security is a moveable asset); and

2. the actual form that any enforcement proceedings may take.

The aircraft being an SPV-owned asset offers financiers dual enforcement options. Enforcement can be taken against the asset itself (via mortgage enforcement) or against the SPV (via share charge enforcement), whereby the financier takes control of the SPV and the underlying aircraft asset.

Economic ownership/Risk

Under a finance lease the residual value of the aircraft at the end of the financing term will vest with the Lessee. Once the underlying debt has been fully amortised (by the payment of rent under the lease) the Lessee will take title to the aircraft. Finance leases typically set out the mechanics of the Lessee acquiring the aircraft and the amounts payable at the end of the lease term by way of a purchase option. This differs from the position under operating leases where the Lessor retains the ultimate beneficial ownership of the aircraft and as such bears the residual value risk. Under a finance lease, it is in the Lessee's own interest to protect the value of the aircraft and the structure and, unlike in operating leases, does not allow for the Lessee to mitigate or offset this risk to its counterparty in the lease.

In summary, a Lessee's decision as to whether to enter into a finance lease will be dictated largely by the needs of their business and the market conditions prevalent at the time. The decision of a Lessee as to whether a finance lease is best for them will be taken once they have reviewed their individual business needs and objectives.

How can Brodies Help?

Our Aviation & Space team are able to advise on the legal implications of finance leases for aircraft. Click here for more information about Brodies Aviation & Space Team.