The Cape Town Convention and the Aircraft Equipment Protocol: Protecting the registered secured interests of airline lessees

B. Patrick Honnebier

Of Counsel

Gomez & Bikker

Amsterdam

1.      Introduction

Most articles concerning the financing of aircraft equipment focus on the interests of the lessors of aircraft equipment. The fact that the lessors need adequate protection has been discussed since the early days of the aviation industry. The same is true with regard to the secured interests of other kinds of financiers of aircraft objects. As a result of these discussions, from the 1930s onwards the national property laws of many countries provided the lessors and other investors with some form of protection, albeit that to a large extent the contents and effects of the afforded protection still vary substantially from state to state. Moreover, after both the Convention on International Interests in Mobile Equipment (Convention or CIME) and the Aircraft Equipment Protocol (Protocol or AEP) will have entered into force, the rights of the lessors and other financiers will finally be protected by an international proprietary regime[1]. In practice, the Convention is also called the Convention of Cape Town, as it has been realised in that city in November 2001. The CIME has entered into force on 1 April 2004. It is only valid, however, as regards a category of objects to which a Protocol[2] applies (article 49(1) CIME). It is expected that the AEP will enter into force towards the beginning of 2005. Therefore, the “Convention on International Interests in Mobile Equipment as applied to aircraft objects” will be put into effect at the same time[3]. Consequently, in the very near future the investors in aircraft objects will be adequately protected at the global level.

This article**, however, focuses on the existing national and international secured interests of the lessees of aircraft (airline-lessees). Particularly,  it addresses the matter of the needed protection of a lessee when the lessor defaults and becomes bankrupt[4]. This issue entails the following two questions. First of all, the question arises under which circumstances a particular airline lessee can be the holder of a secured interest. This question has to be answered on the basis of applicable national property law. For example, under the existing national property law of the Netherlands and the United States the lessor of the aircraft may grant the airline company a secured interest to ‘acquire’ or ‘possess’ the aircraft. The same holds true for the states that have secured interest regimes which are similar to those of the Netherlands[5] or the United States[6]. This kind of secured interest is a full ‘right in rem’, as opposed to a ‘right in personam’.

In all these countries the airlines greatly value their acquired secured interests, particularly in the following scenario which concerns a simple leveraged lease structure. Assume that a lease agreement has been concluded between the lessor and the airline lessee. Furthermore, the lessor has borrowed money from the lender to be able to finance the acquisition of the aircraft. The lessor/borrower has granted the lender a security interest in the aircraft. At one point in time, the lessor/borrower defaults under the loan agreement. The lessee, however, is not in default under the lease agreement. Consequently, the lender may wish to enforce its rights against the lessor/borrower by foreclosing the equity. In that case, the Dutch and American airline lessees can uphold their secured interests against the lender and any other creditors of the bankrupt lessor, provided that their interests were recorded first in time in the national registry.

Secondly, the very important question has been raised whether the national secured interests of airline-lessees, in turn, fall under the sphere of application of the Convention and Protocol. This paper argues that these interests of the lessees can be covered by the Convention and Protocol. It does, however, respect the need to protect the interests of the solvent lessor and its lender. It is in no way trying to undermine the protection that the Convention and Protocol provide to the financiers and investors. In the example that has just been given, it is assumed that the interests of the lender are adequately protected by these instruments. The lender will exercise its remedies and will be paid when the lessor defaults. However, this article also assumes that the sums collected by the lender exceed the amount that is secured by its interest. In that case, the lender must distribute the surplus that it received among the holders of subsequently ranking registered international interests (Article 8(6) CIME).

In this scenario it is not clear, however, whether the interests of the airline-lessee are also preserved by the regime of the Convention and Protocol. Can the airline company uphold its interest against third parties or the lessor’s bankruptcy trustee? To be governed by the CIME and AEP the national secured interests of the Dutch and American airline lessees must, in turn, fall under the definition of an international interest. If the interest of an airline lessee can be the basis of international interests, the lessor may grant the lessee the special remedies created by the new international regime. Furthermore, the registered international interest of the airline-lessee can be upheld against third parties and it has effect in the insolvency proceedings of the lessor, provided that it has been registered in the International Registry before the commencement of such proceedings. As has been noted earlier, this paper argues that the national secured interests of the airline lessees can be covered by the Convention and Protocol. More specifically, it proposes that as long as under the national law of a specific Signatory State a lessor can grant an airline company a security interest, this interest is governed by the new regime.

This article is structured as follows. For the purpose of legal analysis, it will first examine the existing national secured interest regimes covering the financing of aircraft in the Netherlands and the United States more extensively. Therefore, in the next paragraph it will focus on the Dutch secured interests of the airline companies. Next  it will pay attention to the rights of American airline lessees. Afterwards, it will argue that the secured interests of Dutch and American airlines are covered by the Convention and Protocol. Furthermore,  it will look into the matter of other interests in aircraft that are not adequately protected by the Convention and Protocol. Finally, this paper will be rounded off with some concluding remarks.

2.      Dutch law provides for the creation of secured interests of airline lessees

Back to the first question: under which circumstances can secured interests be granted by the lessors to the airline lessees? The lessees can be awarded these interests, provided that the applicable national property law permits this! The Netherlands is a good example of a jurisdiction that has such a property regime in relation to the financing of aircraft. Until after the Second World War, Dutch property law was inadequate in relation to the financing of aircraft objects. For example, an aircraft could be encumbered with a pledge but not with a mortgage. The nature of the then existing pledge legislation, in particular the requirement that possession of the pledged object be transferred to the financier, gave rise to major problems in practice. In 1957 the Registered Aircraft Act (RAA) was enacted in the Netherlands. This act made it possible to establish mortgages in respect of large registered aircraft. Furthermore, from then on a right in rem (real right) in the acquisition of an aircraft could be granted to a Dutch airline. Moreover, the airline could be granted a right in rem to possession by virtue of a lease agreement for longer than six months. Provided, however, that these secured interests had been laid down in the deed of a civil law notary which had been recorded in the national public registry. In 1996, for reasons of convenience, the RAA was inserted into Title 15 of Book 8 of the Dutch Civil Code (DCC), entitled ‘Aircraft’. This legislation provides for the rules on the special property law status of registered aircraft. The functional Dutch air law is considered to be a lex specialis and it must be interpreted autonomously. Dutch law has a closed system of proprietary rights. The only secured interests of which a registered aircraft can be the subject-matter are ownership, mortgage and the rights of the airlines to acquire or possess an aircraft (Article 8:1308 and 8:1309 DCC).

The Dutch secured interests[7] of the airline lessee find their roots[8] in the Convention on the International Recognition of Rights in Aircraft (Geneva Convention, 1948). In turn, the Geneva Convention rights are derived from the pre-Article 9 UCC property laws of the various States of the United States. More specifically, the Dutch secured interests are the equivalents of the conditional sale and equipment trust devices that were used in New York and Pennsylvania. These old American transactions afforded protection to the conditional buyer and lessee, respectively. Presently, these pre-Code arrangements fall under the application of Article 9 Uniform Commercial Code. It was not the intention of the American legislator to abolish these special interests of American airline companies[9].

3.      American law provides for the creation of the secured interests of airline lessees

Moreover, this article contends that the current version of Article 9 UCC establishes that a security interest to acquire or possess the aircraft may be granted by the lessor to the airline lessee. The following scenario will clarify the matter. Assume that a specific transaction is characterised as an American lease (Article 2A UCC). In that situation the lessor may provide the lessee with a security interest in the lease aircraft to secure the lessor’s obligation(s) under the lease (Article 9 UCC). For instance, the lessee may want to seek protection against the lessor bankruptcy trustee’s potential rejection of the lease. In that case, the lessee wishes to avoid an unsecured claim for damages. By taking a security interest it obtains a secured claim[10]. Furthermore, such an interest can be recorded separately from the lease agreement with the Federal Aviation Administration (FAA). One of the most important features of the UCC is the practically uncontrolled freedom it gives the parties to arrange their transaction. Under the Code the parties can provide each other with security interests. It does not matter which party has title to the object. Besides, Article 1–201 (37) UCC, which lays down the basic definition of a security interest, extends its applicability to transactions that have their roots in sales transactions. It states that a buyer may also acquire a security interest by complying with Article 9. The term buyer includes a lessee under a lease agreement. In fact, every party may acquire a security interest, provided that it complies with the requirements of Article 9. It applies to any transaction which is intended to create a security for payment of money or the performance of any other obligation in personal property[11]. Therefore, the obligation secured does not need to be a monetary obligation. For example, the lessee can obtain a security for the lessor’s contractual obligation to provide the lessee with title to or possession of the object. Under the UCC this party can secure the lessor’s obligation. Upon the creation and perfection of the security interest, by filing it with the FAA, the lessee is a secured party. When the lessor becomes insolvent, the lessee’s secured claim is effective against third party claims and the lessor’s bankruptcy trustee. In sum, so long as the lessee has complied with the formal requirements of Article 9 UCC this provision affords it adequate protection. Finally, under the Code the holder of a perfected security interest can also claim its priority status, enforce its special remedies and recover the object. Evidently, whether a lessor will in fact provide an American airline lessee with a security interest depends, among other things, upon the economic and financial leverage of the parties in a specific situation. Also cultural differences, between one state and another, may play an important role. For instance, more than ever before in the Netherlands the American and other lessors grant Dutch airline lessees secured interests. This is not, or may be not yet, the case in the United States where the lessors still seem to be reluctant to provide the lessees with these interests. In turn, all the security interests governed by Article 9 UCC, including the conditional sale, equipment trust and lease, can create international interests under the Convention and Protocol by complying with the formal requirements of these instruments. The reason for this is that these national secured interests are, without any doubt[12], covered by the category: ‘interests granted by the charger under a security agreement (Article 2(2)(a) CIME))’.

4.      The secured interests of airline lessees are protected by the Convention and Protocol

Back to the second question: do the secured interests of the airline lessees fall under the sphere of application of the Convention of Cape Town and the Aircraft Equipment Protocol? The answer is yes, provided that these interests[13] are covered by the very broad description of an international interest. The Convention and Protocol provide for the constitution of a consensual[14]  international interest in aircraft objects. However, neither the Convention nor the Protocol contains a precise definition of the term international interest. Article 2(2) of the CIME merely provides the following general description: “...an international interest in mobile equipment (aircraft) is an (national) interest...: a) granted by the chargor under a security agreement; b) vested in a person who is the conditional seller under a title reservation agreement; c) vested in a person who is the lessor under a leasing agreement”.

It follows from this provision that specific interests which are constituted by a national security agreement, title reservation agreement and leasing agreement can be the basis of an international interest. The characterisation of these legal devices is of great importance since they alone can form the basis of a consensual international interest. The above-mentioned Dutch and American secured interests do not belong to categories b) and c), as they are not interests vested in the conditional seller or lessor. However, they do fall within category a) for the following reasons. The Convention contains a very broad definition of a security agreement (Article 1(ii) Convention), which needs to be filled in at the Dutch or American level. Basically, the term ‘security agreement’ encompasses all types of agreements within a legal system, which have the broad security function set out in the definition. The national legal devices that fall under this definition are not clarified in the Convention or Protocol and they are not enumerated either. In general, the term security agreement can be tailored to aircraft as follows: “A security agreement is in principle any agreement, irrespective of the term assigned to it, through which, under the applicable national law of a Contracting State, a right in an aircraft is constituted whose purpose is to provide a chargee with security in respect of the payment of a sum of money or of the fulfilment of another obligation.” A specific Dutch or American interest must be characterised on the basis of the applicable national law. The chargee can be, for example, a Dutch or American lessor or lessee, a German mortgagee, a Belgian pledgee , a British chargee, a Canadian secured party or any other holder of a consensual right in rem.

5.      Other interests in aircraft are not adequately protected by the Convention and Protocol

As mentioned above, the Convention and protocol recognise the existence of consensual international interests. The effects of an international interest are very extensive, as the regime provides its holder with the following protection. The lessor may award the airline lessee special remedies which can be effectuated when the lessor defaults (Articles 8 CIME and IX Protocol). Furthermore, the CIME/AEP deals with the effects of an international interest against third parties. However, this interest can only be upheld against competing claimants if it has been perfected by registration in the International registry. This international registration system will be operated by the company Aviareto in Shannon, Ireland. The International Registry will be up and running towards the beginning of 2005. The organisation ICAO will be the Supervising Authority. Its task is to oversee that Aviareto performs its duties according to the requirements of the Convention and Protocol. A registered international interest has priority over any other interest subsequently registered and over an unregistered interest (article 29 CIME). An international interest also has effect in the insolvency proceedings of the debtor, as long as it is registered prior to the commencement of such proceedings (Article 30 CIME). In that situation it ranks ahead of claims of subsequently registered interests and those of unsecured creditors. To be able to give clear notice of the existence of the international interest of the airline lessee to third parties, it is advisable to register it separately from the interest of the lessor. Evidently, in practice the international interest of the lender will be registered first in time, the interest of the (not yet defaulting) lessor afterwards and the interest of the airline lessee last. The priority of competing interests, however, may be varied by an agreement between the holders of these interests (Article 29(5) CIME).

The Convention and Protocol also recognise other specific interests of a consensual nature. Under the applicable national property regimes[15] these kinds of interests are regarded, however, as personal rights. Consequently, they do not have the same legal status as the real rights (rights in rem) of the Dutch and American airlines which have been discussed earlier. Under Article 29(4) CIME, to a limited extent, the personal interests of a lessee of an aircraft object may be protected. This provision establishes a limited priority rule. This rule implies that the lessee’s national personal interest has priority over a subsequently registered international interest and over an unregistered interest. The provision creates the possibility for the lessee to have its interest notified in the International Registry. However, the lessee does not itself possess a registrable interest. It can merely rely on the lessor to register its international interest in the international registration system. The registration of this international interest will also give third parties notice of the interest of the lessee. Under the Convention and Protocol the non-registrable interest of the lessee and the registered international interest, however, do not have the same effect. For example, these instruments do not provide a lessee that has a personal interest with the special default remedies which have been discussed earlier. Consequently, the personal interest of the lessee is not given full and equal protection as is provided to the holder of an international interest. Therefore, it would not be advisable for a Dutch or American airline, which has been granted a secured interest by the lessor, to seek the limited protection which is afforded to a lessee’s personal right under Article 29(4) CIME.

6.      Concluding remarks

The Dutch and American secured interests of the airline lessees to acquire or possess an aircraft belong to the category: “an interest granted by the chargor under a security agreement”. This means that they can be the basis of international interests and that they fall within the sphere of application of the Cape Town Convention and the Aircraft Equipment Protocol. These interests can be effectuated as follows. The CIME and AEP provide for special remedies, which are available to the lessee in the event that the lessor defaults. These remedies only relate to the parties inter se. For an international interest to be invoked against third parties it must have been recorded in the International Registry. A registered interest has priority over any other interest subsequently registered and over an unregistered interest. In principle, the priority of competing interests may be varied by an agreement between the holders of those interests. For example, the parties may agree that the international interests of the lender and the lessor may be entered in the International Registry before the international interest of the airline lessee. Furthermore, the lessee’s interest is effective vis-à-vis competing claimants in the insolvency proceedings of the lessor, provided that it was registered prior to the commencement of these proceedings.