The Cape Town Convention: Key Issues for the Practitioner
March 2006 brought about a sea-change in the aircraft industry worldwide with the ratification and implementation of the Convention on International Interests in Mobile Equipment (the “Convention”) and the Protocol to the Convention on International Interests in Mobile Equipment on Matters Specific to Aircraft Equipment (the “Protocol”) (the Convention and the Protocol are collectively referred to herein as the “Treaty”), both signed in Cape Town, South Africa on November 16, 2001. The Treaty created a new legal concept – the “International Interest”, changed the rules for perfecting priorities and legal rights in aircraft equipment, and added additional requirements to the perfection of such rights and interests by establishing the Cape Town International Registry (herein the “IR”). While this chapter discusses many aspects of aircraft practice in the United States of America in connection with the Federal Aviation Administration Civil Aircraft Registry (“FAA”), the Treaty concepts discussed herein are universal.
For the United States, ratification of the Treaty was done in conjunction with maintaining the FAA as the central repository where all legal interests in aircraft equipment would be filed. The FAA was also appointed to serve as the United States Entry Point to the IR.
At its inception, the Treaty was ratified in 2006 by eight countries, which number has now grown to over fifty, with many more to come in the near future. The purpose of the Treaty is to provide a stable international regime for the protection of creditors, conditional sellers and lessors; however, the implementation and application of the Treaty has created, and continues to create, many issues that the legal community has only begun to examine.
Brief Overview of the Treaty Provisions
The Treaty applies to “aircraft objects”, which include airframes, helicopters and aircraft engines (each an “aircraft object”) that meet the following size requirements: (i) an airframe must be type certificated to transport eight persons including crew or goods in excess of 2,750 kilograms; (ii) a helicopter must be type certificated to transport at lease five persons including crew or goods in excess of 450 kilograms; and (iii) an engine must have 1,750 pounds of thrust (or its equivalent) or 550 rated take-off horsepower (or its equivalent). Aircraft equipment not meeting these size requirements are not subject to the Treaty.
In addition to meeting the size requirements, the debtor, lessee or seller must be “situated” in a Contracting State in order for the interests created by transaction documents to be covered by the Treaty. The location of the creditor, lessor or buyer is irrelevant to Treaty application. Whether a debtor, seller or lessee is “situated” in a Contracting State is a broad concept under the Treaty and while one would normally look to the place where the entity is incorporated or formed, that is not the only factor to consider. The Convention sets out four alternative ways in which an entity may be “situated” in a Contracting State: (i) the location in which the entity is incorporated or formed; (ii) the location in which the entity has its registered office or statutory seat; (iii) the location in which the entity has its centre of administration; or (iv) the location in which the entity has its place of business. If an entity is not formed or incorporated in a Contracting State, but has a registered office or a principal place of business in a Contracting State, that entity could be considered as being “situated” in a Contracting State. Additionally, and of particular import, if an entity is an SPE formed in a non-Contracting State, but the SPE is managed and administered by a parent with offices in a Contracting State, then the SPE would be subject to the Treaty under clause (iii) above.
It is important to note that if the Treaty connecting factors apply, then the aircraft transaction is subject to the Treaty, even if all parties to the transaction are located in the contracting state and it is not anticipated that the aircraft will be used outside of that jurisdiction. After the Treaty came into force, there was a misconception that the Treaty was inapplicable if the transaction was wholly domestic. That misconception is incorrect; the Treaty applies regardless of where the aircraft will be operated.
The priority rule as set forth in the Convention is simple and meant to be transparent – the first to register takes free of a subsequent registration and from a legal interest that is not registered – even if the registering party has actual notice of a prior, unregistered interest. Therefore, filing or registering transaction documents with local state registries (including the FAA) is not enough to protect the legal rights and priorities of the transaction parties. Registration of legal interests with the IR is now an additional and critical step to protection.
Even though the priority rule seems straight-forward, there are several exceptions to the general rule of first to register wins. First, contracting states are permitted to opt in or out of certain provisions of the Treaty, one being whether there are non-consensual liens that would have priority over a registered interest, even though the non-consensual lien is not registered. Second, pre-existing interests in the relevant jurisdiction may retain priority even after Treaty ratification in that jurisdiction. Third, the priority rule may be varied by agreement among the transaction parties. Thus a party to an interest may agree to subordinate its interest to an interest registered later in time. For example, if the owner of an aircraft leases the aircraft prior to entering into a security agreement with a lender, that lender will (most likely) require that the previously registered international interest be subject and subordinate to the international interest registered pursuant to the security agreement. If the parties agree that the previously registered lease should be subordinate to the international interest created by the security agreement, then the parties should also register the subordination of the international interest created by the lease, otherwise the subordination will not bind an assignee of the subordinated interest. Fourth, the Revised Official Commentary to the Treaty points out that states may give different weight to the Treaty, as international law, such that the Treaty provisions may be subject to differing interpretation depending on the state in which a priority question arises.
Notwithstanding the possible exceptions to first to register wins, it is essential to register interests with the IR to protect the transacting parties’ priority in aircraft equipment. Registration with the IR is completely electronic through a web-based system; however, the Treaty requires that the international interest be in “writing”. Parties must also determine whether the underlying documents need to be filed with the appropriate aviation authority as required in a particular jurisdiction. In some cases, filing the underlying documents with the appropriate aviation authority is a requirement under the Treaty in order to comply with the jurisdiction’s entry point requirements. For example, the United States has designated the FAA as the entry point for all transactions involving aircraft registered in the United States, and Mexico has designated the Dirección General de Aeronáutica Civil as the entry point for all transactions involving Mexican registered aircraft. It is important for a practitioner to confirm whether the jurisdiction that governs the transaction has designated an entry point because the entry point requirement must be satisfied in order to register the interests created by the transaction documents.
In the United States, in order to complete a registration against an airframe, helicopter or engine on the IR, the parties must first file the transaction documents with the FAA. At the time of filing with the FAA, the parties must also submit an FAA AC Form 8050-135 FAA Entry Point Filing Form International Registry (“135 Form”). The 135 Form is an unsigned form submitted to the FAA in order to comply with the designated entry point requirements for aircraft registered or to be registered in the United States. The purpose of the 135 Form is to allow a user to obtain a Unique Authorization Code (“UAC”) for entry on the IR - the 135 Form is not intended to create (i) an instrument or conveyance that is recordable with the FAA, or (ii) an interest in the airframe, helicopter or engine.
Each party to an IR registration must have a valid Transacting User Entity (“TUE”) account on the IR, through which each party will appoint a person as its Cape Town Administrator, who can be an employee of the party or an outside agent (the “Administrator”). The IR is a two-party system and requires that both parties to any transaction have a TUE account. It is critical to check the TUE status prior to any transaction, as the process to set up a TUE account can take anywhere from two to five business days. If the Administrator is an employee of the party, it is important that the Administrator still works for the party and is available prior to the closing. As aircraft closings are often time sensitive, the maintenance and ongoing work of a TUE Administrator is not for the light-hearted.
Additionally, prior to closing the transaction, the law firm or title company that will be closing the transaction must request Professional User Entity (“PUE”) status from each of the transacting parties for the specific pieces of equipment that are subject to the transaction. A TUE can appoint another entity as its PUE but the appointment is for each specific piece of equipment – it is not a blanket authorisation. Being appointed the PUE gives the PUE entity the ability to register interests on behalf of the TUE for that specific piece of equipment but not the authority. The transacting parties, once the PUEs are in place, must still authorise the PUE, during the closing call or by email, to effect the necessary registrations.
Assignments and Novations
The rules regarding assignments and novations under the Treaty are complex, and, at times, confusing. In order for an assignment to fall under the Treaty, the assignment must assign the “associated rights”, which are defined in the Convention as “all rights to payment or other performance by a debtor under an agreement which are secured by or associated with the object”. Article 32 of the Convention sets out the formal requirements for an assignment of associated rights that transfer the related international interest: the assignment must (i) be in writing, (ii) enable the associated rights to be identified under the contract from which they arise, and (iii) in the case of a security assignment, enable the obligations secured by the assignment to be determined in accordance with the Protocol. If an assignment does not also assign the associated rights, then it is ineffective under the Treaty to transfer the related international interest.
Whether an assignment is considered a novation is a matter of applicable local law; therefore, in order to make sure the new creditor is properly perfected in the case of an assignment or novation, the safest approach is to (i) register an assignment of the original international interest by the prior creditor, as assignor, in favour of the new creditor, as assignee, and (ii) register a new international interest between the new creditor and the debtor. The reason for this approach is because if the assignment is considered a novation under applicable local law, then the registration of an assignment of the original international interest has no effect since the original registration would be considered terminated. If the assignment is considered a novation under applicable local law and the parties do not register a new international interest on the IR, the rights of the new creditor would not be properly perfected. The only way to be sure the new creditor is properly perfected is to register both the assignment of the underlying international interest and a new international interest. This approach may seem duplicative; however, since there is some uncertainty over how a court would view the registration of an assignment if the assignment is considered a novation, the best approach is to do both registrations.
Under the Treaty, the only party that can discharge a registration is the creditor under and named in that registration. Prior to 2010, when an assignment of an international interest was registered, the new creditor would be able to discharge the assignment when the obligation of the debtor had been satisfied, but it would not be able to discharge the underlying international interest without action from the original creditor. Only the original creditor named in the registration could make the discharge. As one can imagine, this created several problems because one would need to locate and request the cooperation of the original creditor in order to discharge the underlying international interest even though the original creditor had since transferred all of its interest to the new creditor. This issue became quite a problem for practitioners in the aircraft industry because there were many cases in which the underlying international interests could not be discharged if the original creditor no longer existed or could not be located. Additionally, if the original creditor’s TUE account had since been disabled or suspended, there was no way to discharge the underlying international interest without locating the original creditor and asking that entity to re-establish its account (and pay the IR fee to do so). Also, since all registrations require that there be a “writing” to support the registration, it was necessary to obtain something in writing from the original creditor authorising the discharge of the underlying international interest, even though that entity no longer had any interest in that equipment.
One way some parties dealt with this issue was to obtain a side letter from the original creditor (i) authorising the discharge of the underlying international interest at such time as the new creditor discharged the assignment, and (ii) agreeing not revoke the PUE appointments, such that the escrow company or law firm which registered the assignment could also complete the discharge of the underlying registration at the appropriate time. While getting such a side letter at the time the transaction closed was a good idea, practitioners still ran into the problem of TUE accounts being suspended and/or disabled.
This problem was addressed in 2010 when the IR was updated to include a new function – the transfer of the right to discharge (“RTD”). After 2010, if an assignment was registered, the parties could also register a transfer of the RTD the underlying international interest to the new creditor. Once the RTD is transferred to the new creditor, the original creditor is completely out of the equation and is not needed to complete any further action when the underlying international interest needs to be discharged. It is important to note that while it is now possible to transfer the RTD on the IR, it does not happen automatically once an assignment is registered; the transfer of the RTD is a separate registration that must be completed after the assignment.
The new RTD functionality of the IR is also useful for lessors, owners or lenders such that the RTD can be held by the senior creditor in connection with junior registrations made, for example a lease, so that the senior creditor can discharge the junior registrations when the transaction has been completed or if there has been a default. Without the RTD in the control of the senior creditor, the senior creditor would have no ability to clear the IR of registrations to convey clear title to a third party.
Finally, since the RTD is a relatively new feature of the IR, it may prove useful for practitioners to review transactions that occurred prior to 2010 to determine if registrations were made where the original creditor has assigned its interest and is no longer involved in the transaction. If so, then registering a RTD now could save money and aggravation in the future when the original registration needs to be discharged but the original creditor is long gone. In any event, there are now and will be more transactions where original registrations cannot be discharged and will remain on the IR even though the transaction has terminated and no rights exist under those registrations. This will test the aircraft community to determine how to address these registrations in future closings and legal opinions in a way that will not be a detriment to healthy aircraft commerce.
Registration of Leases
Leases are covered by the Treaty and constitute international interests that should be registered in order to properly perfect the interests created thereby. It is important that all leases be registered on the IR for the protection of the lessor because under the Treaty a lessee has the “power to dispose” of the aircraft object. If a lease is not registered and the lessee wrongfully sells the aircraft, the lessee’s purchaser acquires an overriding title displacing that of the owner/lessor because of the lessee’s power to dispose under the Treaty. Since the power to dispose arises under the Convention, the only way a lessor can protect its interest in the aircraft object is by registering its lease on the IR. This holds true for any subleases of aircraft objects as well.
It is important to note that whether a document is considered a “lease” under the Treaty is a matter of applicable local law. In some cases, a management agreement could rise to the level of being considered a lease under applicable local law. If a management agreement transfers possession or control of the aircraft to the manager, and there is some kind of consideration paid by the owner to the manager, this arrangement, though only intended to be a management agreement, could be viewed under applicable local law as being a lease. If the management agreement meets the definition of “lease” under applicable local law, then it should be registered on the IR in order to properly perfect the interests of the owner.
Refinancing, Amendments and Lease Extensions
Careful examination is necessary in connection with any amendment to a credit agreement, security agreement or lease in order to determine whether such amendment will have an impact under the Treaty. While some amendments will give rise to new international interests, others will not and it is important to recognise the difference between the two. The biggest difference between amendments that will and those that will not give rise to new international interest registration is whether the amendment materially alters or fundamentally changes the underlying documents so much so that the amendment is essentially creating new obligations not previously covered by the underlying document. On the other hand, if the amendment is merely changing the method of payment, amending the maintenance or insurance provisions or documenting a name change for the creditor or debtor, then those amendments will not give rise to new international interests.
Under the Treaty, if an amendment gives rise to a new international interest, then the creditor must register the new interest in order to properly perfect its interests, since the new interest created by the amendment would not be protected by the initial registration. Amendments that modify the payment terms, increase a lease term, increase the loan amount or extend a security interest to an obligation not previously secured are examples of the types of amendments that would give rise to a new international interest, and such amendments would not be protected by the initial international interest registrations.
A refinancing or amendment to a credit agreement that changes the payment terms, extends the maturity date or increases the amount of the loan would also give rise to new international interest, and such actions would not be protected by the initial registrations. When dealing with United States law, the parties will also need to amend the underlying security agreement, and file the amendment with the FAA in order to comply with the United States’ entry point requirement. As noted above, the FAA is the entry point to the Convention for the United States, thus in order to register any interest involving aircraft registered in the United States, transaction parties must first file the documents with the FAA and obtain a UAC. Once the FAA has issued the UAC, the parties may then proceed to register the new international interests on the IR.
Similarly, a lease amendment that extends the term of a lease will also give rise to a new international interest because the extension to the term is a new obligation not covered by the original international interest registration. In order to properly perfect the interest created by a lease extension, the parties must register a new international interest because the extension is materially altering the initial term in the underlying lease, such that the extension is not covered by the international interest registration completed in connection with the underlying lease.
In 2008, the Revised Official Commentary to the Treaty (“ROC”) created yet another change to the perfection of rights and interests in helicopter engines. The ROC makes a distinction between aircraft engines and helicopter engines, stating that when helicopter engines are installed on a helicopter they become components of the helicopter and not a distinct “aircraft object” and, therefore, for the period of time a helicopter engine is installed on a helicopter it does not fall within the definition of “aircraft engine”. The ROC also suggests that helicopter engines could be classified as “aircraft engines” before installation and after removal from a helicopter. Accordingly, depending on whether a helicopter engine is installed on or removed from a helicopter, helicopter engines may not be covered by the Treaty, and helicopter engines which are attached to a helicopter may be subject to an international interest registered against the helicopter to which such helicopter engine is attached.
Since the ROC took this position in 2008, parties have to be extremely diligent regarding helicopter engines and the status of installation of such engines. Also, companies have had to be more mindful of this issue prior to completing any engine swaps within its helicopter fleet. For example, if helicopter A and helicopter engine A are pledged to lender A, and helicopter B and helicopter engine B are pledged to lender B, under the ROC if helicopter engines A and B are swapped (such that helicopter engine A is installed on helicopter B and helicopter engine B is installed on helicopter A), then helicopter engine A would be subject to the international interest in favour of lender B and helicopter engine B would be subject to the international interest in favour of lender A. Companies that have multiple helicopters in their fleet that are subject to security interests in favour of different lenders now have to be mindful of the above scenario when swapping engines in their fleet and also discuss the above scenario with their lenders in order to avoid the situation discussed above.
Parties to transactions involving helicopter engines have dealt with this issue in various ways. Some helicopter leasing companies have required that the lessee represent and warrant in the lease agreement that the helicopter engine covered by the lease will not be installed on a different helicopter, the reason being that if the helicopter engine is installed on a different helicopter, then under the ROC the helicopter engine would become a component of the new helicopter and subject to the same legal interests as the helicopter. Another approach utilises intercreditor agreements whereby all lenders agree that liens will follow the helicopter engines no matter the status of installation of the helicopter engines; however, whether such agreement would stand up in court or a bankruptcy remains unanswered.
Additionally, parties can include language in their transaction documents stating that the parties agree that the helicopter engines will be considered “aircraft objects” under the Treaty regardless of whether or not the helicopter engine is currently installed on a helicopter. While this is a self-serving statement, if the issue were to arise to the level of litigation, the statement would show the parties’ intent that the helicopter engine be considered an “aircraft object”.
Furthermore, the ROC has changed what parties register on the IR at the time of a closing involving helicopter engines. Since the ROC states that a helicopter engine is not an “aircraft object” if installed on a helicopter, parties to a transaction will register (i) a current interest against the helicopter engine, and (ii) a prospective interest against the helicopter engine. The reason for registering essentially duplicate interests on the IR is that the current interest takes care of the interest created by the transaction documents at the time of the closing, while the prospective interest will vest if and when the helicopter engine is ever removed from the helicopter, at which time the helicopter engine would be considered an “aircraft object” under the Treaty. The registration of both a current interest and a prospective interest is done in order to cover all bases and make sure the creditor is protected no matter the status of installation of a helicopter engine.
While the stated purpose of the Treaty is a simple concept and in theory works very well, in application the Treaty has created, and continues to create, issues that practitioners are only beginning to examine. As with any area of law, application and interpretation of the Treaty concepts and protections is an evolving process. Over the coming years, case law will shed more light on several of these issues that are unsettled. But until then, knowledge of the issues and how the industry is dealing with them is critical to full representation of clients in aircraft transactions.
Other Recent Articles
September 6, 2017 | McAfee & Taft EmployerLINC
September 5, 2017 | McAfee & Taft tIPsheet
August 31, 2017 | The Journal Record
August 9, 2017 | McAfee & Taft EmployerLINC