• Aircraft Leasing Update: Second Circuit Gives Liftoff to Billions in Unsecured Tax Indemnity Claims
  • April 18, 2011 | Authors: Elizabeth H. Evans; Michelle F. Herman
  • Law Firm: Jones Day - New York Office
  • When an airline goes bankrupt, do the owner participants in aircraft leverage-lease transactions have a right to recover on monetary claims (worth billions) based on tax indemnification agreements ("TIAs")? The answer lies in the meaning of the words "pay/paid/pays," which had been the subject of conflicting interpretations in the bankruptcy and district courts in the Northwest Airlines and Delta Air Lines bankruptcy cases.

    The effect of these bankruptcy and district court decisions was that owner participants were considered paid as a result of the discharge of the debtor even though they never recovered a cent on account of the TIAs. On June 22, 2010, the U.S. Court of Appeals for the Second Circuit overturned a ruling by the bankruptcy and district courts and held that in the context of the Delta leverage lease agreements, the owner participants' claims would be allowed. The decision affected the entire leverage leasing industry, including real estate, aircraft, and equipment leverage leases—and its repercussions are still being felt.

    In Northwestern Mutual Life v. Delta Air Lines, Delta had entered into leverage leasing arrangements, whereby an owner trust was established to purchase aircraft with funds provided by (1) an equity contribution from the owner participant of approximately 20 percent of the purchase price of the aircraft and (2) nonrecourse borrowing from lenders of the remaining 80 percent. The owner trust, as "lessor," then leased the aircraft on to the operator. The primary incentive of the owner participant in such a leverage lease transaction is to obtain tax benefits, and this important factor induces the owner participant to allow the owner trust/lessor to lease the aircraft to an operating lessee at a lower cost than would otherwise be available in the market. Rental payments are treated as income, but interest payments on the outstanding debt are deductible, as are transaction expenses (over time). More importantly, owner participants are entitled to take accelerated depreciation deductions with respect to the aircraft. The excess of these deductions over the rental income may be used to offset other income of the owner participant, or other income in the consolidated tax group of which the owner participant is a member.

    Each owner participant in Delta Air Lines relied on two mechanisms to protect against certain risks that might prevent utilization of the tax deductions: (1) a TIA, pursuant to which the airline compensates the owner participant for any "recapture" of prior tax deductions and (2) a provision in the lease that permits the lessor (or the indenture trustee as assignee of the lessor's interest for the benefit of the lenders) to demand the airline pay "stipulated loss value" ("SLV") or "termination value" in the event of default. SLV is typically calculated to provide for the payment of the remaining debt and interest, and any remaining funds, to the owner participant reflecting an agreed-upon return, sufficient to cover all adverse tax consequences of an event of default. In order to avoid the owner participant receiving double compensation for a tax loss (that is, under the TIA and also as a portion of SLV), each TIA contained an exclusionary provision, which stipulated that, in the event Delta "pays" SLV under the lease, the owner participant is excluded from collecting under the TIA.

    To resolve numerous TIA claims, the bankruptcy court employed a test case approach by analyzing similar contractual language in three slightly different TIAs. The three exclusionary provisions were as follows:

    An owner participant shall not be entitled to any payment from Delta when (1) "[Delta] pays an amount equal to Stipulated Loss Value", (2) "[A] party to any of the operative documents is required to pay Stipulated Loss Value," and (3) "[Delta] pays the Stipulated Loss Value or Termination Value or an amount determined by reference thereto."

    Delta objected to the owner participants' claims under the TIAs, and the bankruptcy and district courts upheld the objections for the following reasons. As to case 1, relying on the meaning of "pay," the bankruptcy and district courts held that payment occurs through satisfaction of a debt by money or property sufficient in fact or law to discharge the obligation. Because each indenture trustee's claim for SLV would be discharged in accordance with Delta's confirmed plan of reorganization, each SLV had been "paid" under the law.

    As to case 2, the bankruptcy and district courts found that in any case where the indenture trustee demanded payment of SLV (as was the case when Delta defaulted), Delta was "required to pay" SLV.

    Finally, as to case 3, the courts held that "an amount determined by reference [to SLV]" was "paid" when the indenture trustee either (1) received a percentage of SLV net of the sale proceeds of the aircraft in a foreclosure sale or (2) used SLV as a starting point to calculate lease rejection damages in reaching settlement with the lessee, the amount thus being determined by "reference" to SLV.

    The Second Circuit rejected the bankruptcy and district courts' literalistic approach and conclusions and focused instead on the intent of the parties. Finding that the purpose of the exclusionary provisions was to ensure the owner participant not receive double compensation—under both the TIA and through the SLV "waterfall"—the court held that only payment in full of the SLV would exclude Delta from paying the owner participant under the TIA. Adoption of the bankruptcy court's construction of "pay" would have nullified Delta's obligation to pay the owner participant under the TIA upon the very occurrence most likely to call its provisions into play—Delta's insolvency. The bankruptcy court in Northwest Airlines, in which claims are still pending, reached similar conclusions.

    While lessees in other bankruptcy proceedings have advanced various other objections to TIA claims, Delta Air Lines and Northwest Airlines had introduced objections specifically targeted at the application of the exclusionary provision of the lease. The Second Circuit decision thus stands as a clear win for owner participants, as it undeniably confirms (at least in that Circuit) the owner participants' right to recover ratably for their claim along with other unsecured creditors. Of course, despite the decision, it is still best practice for owner participants to use the words "paid in full Stipulated Loss Value such that the owner participant is paid in full the amount that would otherwise be due and owing from the lessee under the TIA" when drafting the exclusionary provisions in leverage lease documents.

    In the wake of the decision, a variety of companies have traded and monetized their Delta TIA claims. Beyond the immediate implications of the decision on owner participants in the Delta bankruptcy is the impact the Second Circuit decision will have on negotiations of settlements between the debtor and the lessee over lease rejection damages. Delta had reached a settlement with its debtholders regarding such damages and, as part of its argument to the court, had asserted that recovery by the owner participants would result in Delta having to make duplicative payments. The Second Circuit equally rejected this motion, writing "to the extent that this is true, it is Delta's own fault: the problem exists because Delta (and the creditors' committee) agreed ... to pay the Indenture Trustees more than they were entitled to—namely, their share and the Owner Participants'."

    In the future, this holding may either reduce debtholders' recovery or impede settlement as lessees will be concerned that on top of paying the debtholders' claims for SLV (one part of which comprises the owner participant's tax indemnity claim)—rarely in bankruptcy or settlement context to be paid in full—they will need to pay the owner participant pursuant to the TIA.