Dirk Schmalenbach and Johannes Vogel from Freshfields Bruckhaus Deringer LLP give a brief overview of recent economic and legal developments affecting the commercial aircraft leasing market in Germany. In more detail, we will address the recent economic development of the German leasing market, the situation of German KG leasing funds for retail customers, structured leasing products for institutional investors and recent important court decisions relevant for the German aviation market. We will also give a brief outlook into the future by discussing the likelihood of a ratification of the Cape Town Convention and the Aircraft Protocol in Germany and will consider the impact of the introduction of the new accounting rules in “IFRS 16 leases”.
Update on economic development of the German leasing market. Until 2030 industry experts expect the German aviation market to grow from 105 million passengers to 175 million. This translates into a growth rate of 3.3% per annum (source: DLR paper dated January 6, 2016). While the number of aircraft is unlikely to increase, their size and value is likely to grow. It is therefore reasonable to anticipate that also the German aircraft leasing market will be growing correspondingly.
Irrespective of the challenges for German airlines such as the German air traffic tax (see below for more detail) and increasing competition by low-cost and Middle-Eastern carriers, we expect a steady demand for financings in the German airline industry. The challenges might make operating leasing increasingly attractive for carriers as it allows for a mitigation of residual value risks, increased flexibility of the fleet, reduced liquidity needs by eliminating pre-delivery payments and access to attractive delivery slots secured by aircraft lessors.
On the other hand, the current environment of low to negative interest rates drives market participants with a strong credit to the capital markets given the higher volumes and comparably lower transaction cost compared to single aircraft leasing transactions. This may also be driven by the fact that due to the continued application of the home country rule, export credit financings for Airbus aircraft are not available to German airlines.
Situation of German KG leasing funds for retail customers. Since 2000 the German tax legislation has not offered aircraft lessors a specifically attractive environment. However, German closed-end aircraft funds for retail customers are a well-established product combining attractive pre-tax returns with some depreciation benefits. This market suffered during the financial crisis of 2008/09 and has not fully recovered ever since. Certain changes in the German fund legislation introduced by the Kapitalanlagegesetzbuch in July 2013 have made the creation of new funds more cumbersome. Simultaneously, banks have experienced a fair amount of consumer litigation following the Lehman insolvency which has resulted in an increased reluctance to distribute more complex investment products such as aircraft closed-end funds.
It is our observation that following a consolidation in the arranger market the closed-end aircraft fund market for retail customers has been limited to very few offerings for investments in single asset funds for wide-body aircraft leased to top-tier international airlines. The discussion of a potential production end of the A380, once an investors’ favourite, has not helped the distribution of such funds. We would expect though that a combination of airlines with good credit and other modern aircraft should cause the product to remain sufficiently attractive for retail customers, albeit at a low level.
Structured leasing products for institutional investors. We note an increasing interest of German institutional investors such as insurance companies and pension funds for debt and equity investments in aircraft. While aircraft had been a familiar asset class for US institutional investors, for example, for many years, only the introduction of the European Solvency II regime in Germany on January 1, 2016 set the regulatory framework that allows German primary insurance companies to invest in this asset class. Prior to that German primary insurance companies were only permitted to invest into specific asset classes which did not comprise aircraft.
German institutional investors steadily acquaint themselves with aircraft investments. We have seen a growing number of investment offerings in this segment and expect this to be a growing market over the next few years. Senior debt investments into leasing structures for aircraft operated by airlines with good credit are the starting point for this development. Once institutional investors have become familiar with the asset class we see a good chance that the aim for higher returns will increase the interest in mezzanine and equity investments as well as investments into aircraft operated by airlines with a lesser credit. This area provides opportunities for new market participants, may open new customer groups to existing arrangers and leaves room for innovatively structured products.
Recent court decisions affecting the German aviation industry. The German Air Traffic Act (Luftverkehrsteuer - “ATT”) introduced in 2010 has put a significant burden on the German aviation industry. In 2014 almost €1bn was raised hereby. While cargo and transfer passengers are exempt, essentially all tickets for flights originating in a German airport are subject to a tax which ranges from €7.50 for short to €42.18 for long-haul flights. Airlines have challenged the tax in court. A major battle was lost when in November 2014 the German Federal Constitutional Court (Bundesverfassungsgericht) held that the ATT was constitutional. The State of Rhineland Palatine had argued that the Federal Republic was not authorised to introduce such a tax and had pointed out several features which raised doubt as to its compliance with a constitutional equal treatment requirement. Following that decision the industry had hoped that the highest German tax court, the Bundesfinanzhof, would find the ATT not to be compliant with the EU Energy Tax Directive and the rules as to state aid. However, the Bundesfinanzhof in two decisions of December 1, 2015 found no violation of the EU rules and accordingly German and international air carriers operating out of Germany will need to continue bearing ATT unless the Federal Parliament will resolve as to its abolishment. This has been the subject of various parliamentarian requests. However, the ruling grand coalition has shown little appetite in moving in this direction.
While the courts have not helped the industry with respect to ATT, a major lawsuit was won in the highest German civil court, the Bundesgerichtshof (BGH), which if adversely decided could have caused significant financial distress to the German aviation industry.
A consumer protection organisation had challenged the global industry practice also applied by all German airlines which requires a customer upon having booked a ticket to prepay it, even if the flight will take place only in a few weeks or months. The plaintiff here argued that such practice would violate the statutory restrictions on standard form agreements laid down in the German Civil Code. The court held that such restrictions were not applicable to the aviation industry. Otherwise, the carriers would have to transport passengers and be entitled to their fares only upon arrival. This would expose the carriers to a significant risk as they would have no security over the passenger’s assets. On the other hand, passengers were found to be adequately protected by European and national licensing rules for air carriers and the court observed that the industry practice to sell tickets cheaper early would adequately compensate passengers for any loss of liquidity and interest. This pragmatic and well-founded decision of February 16, 2016 should end all discussions in this regard.
Potential ratification of the Cape Town Convention in Germany? It is approximately 15 years since the Convention on International Interests in Mobile Equipment and the Protocol to the Convention on International Interests in Mobile Equipment on Matters Specific to Aircraft Equipment (together the Cape Town Convention) were adopted on November 16, 2001. The aim of the Cape Town Convention was the creation of a uniform and internationally recognised legal framework for aircraft financing, in particular for the creation and enforcement of security interests. An increasing number of countries have ratified the Cape Town Convention. By now approximately 70 countries have done so.
The recent ratification of the Cape Town Convention by the UK raises the question whether a ratification of the Cape Town Convention is likely in Germany in the foreseeable future. This should be primarily dependent on German airlines benefiting from better financing conditions in case of a ratification of the Cape Town Convention. However, this seems not very likely, as the traditional German aircraft mortgage has been recognised as a sustainable security instrument and the German legal system is perceived as reliable in terms of its enforcement. Moreover, export credit financings do not play a major role in recent aircraft financings in Germany given the low interest environment and the home country rule which effectively impedes the export credit financing of Airbus aircraft for German operators. On the other hand, rising interest rates and an increasing number of EU member states that would ratify the Cape Town Convention may increase the appetite of German airlines in the expected advantages of that regime, e.g. for aircraft securitisation structures. The experiences that UK airlines will make in the near future may prove to be a good benchmark for the German airline industry.
IFRS 16 leases and its potential effects on German airlines. On January 13, 2016, the International Accounting Standards Board issued a new accounting standard “IFRS 16 leases” which will take effect as of January 1, 2019. These new rules will apply to German aircraft operators to the extent they do not establish their accounts in accordance with the rules of the German Commercial Code, but also – or alternatively on a group-wide consolidated basis – in accordance with IFRS.
While lessors’ accounting for leases will remain unchanged, “IFRS 16 leases” requires lessees to recognise operating leases as assets and liabilities (with the exception of small item leases of low-value assets, as well as short-term leases with a term of less than 12 months). Traditionally, operating leases were not shown on the lessee’s balance sheet but were only reflected in the notes. In future, lessees will have to account for a right of use of the leased asset and show an obligation to make lease payments. A lessee’s profit and loss statement will record lease expenses comprising of a depreciation component and an interest component. As a result, operating lessees will appear more asset rich and more heavily indebted. Also the lease expenses will be front-loaded from a profit and loss perspective even when the rental payments are equal throughout the lease term. As the depreciation of aircraft will usually be higher than the down-payment of the liabilities “IFRS 16 leases” might increase balance-sheet indebtedness of the lessee.
Lessees will need to assess and consider this and the effects the new accounting rules may have on certain of the ratios typically used in financial covenants of financing arrangements, e.g. an EBITDA covenant. However, the transitional provisions of “IFRS 16 leases” allow for the application of the “IFRS 16 leases” rules to all existing operating lease contracts with retrospective effect or with immediate effect as of January 1, 2019 or for the application of the new rules only to new lease agreements concluded after January 1, 2019. This optionality may well give operating lessees sufficient flexibility to mitigate potential negative impacts.
Many market participants expect “IFRS 16 leases” to negatively affect the attractiveness of aircraft operating leases. Whether this will prove true remains to be seen. In our experience aircraft financiers and lenders to airlines have traditionally accounted for the operating lease expenses in their credit analyses anyway. For them the new rules will not generate any new information which should negatively affect their willingness to finance airlines and aircraft.
Dr. Dirk Schmalenbach is a Partner and Dr. Johannes Vogel is a Principal Associate at Freshfields Bruckhaus Deringer LLP in Frankfurt am Main, Germany. Both are members of the firm’s finance practice and specialised in, amongst others, international aircraft financing transactions.