The Cape Town Convention: An Evolving Process (with a Side Note on Non-Citizen Trusts)
By Erin Van Laanen and Maria Gonzalez
This is the second article for the International Comparative Legal Guide series. Our first article covered 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, which heralded a sea-change in the aircraft industry worldwide. The importance of the Treaty for the aircraft industry cannot be underestimated. Thus, we provide a summary of the important concepts of the Treaty here.
At its inception the Treaty was ratified in 2006 by eight countries, which number has now grown to over fifty, with many countries still working toward ratification. 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.
Since its inception in 2006, the International Registry (discussed below) has evolved and continues to identify areas in which the website and registration process can be improved. In September 2013, the IR went through a major upgrade, Generation II, which is intended to improve the way the website operates and make it more user-friendly, which we summarise below.
Overview of the Treaty Provisions
The Treaty creates a new legal concept – the “International Interest”, changes the rules for perfecting priorities and legal rights in aircraft equipment, and adds additional requirements to the perfection of such rights and interests by establishing the Cape Town International Registry (herein the “IR”).
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 2750 kilograms; (ii) a helicopter must be type certificated to transport at least five persons including crew or goods in excess of 450 kilograms; and (iii) an engine must have 1750 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 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 straightforward, there are several exceptions to the general rule of first to register wins. Firstly, 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. Secondly, pre-existing interests in the relevant jurisdiction may retain priority even after Treaty ratification in that jurisdiction. Thirdly, 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. Fourthly, 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.
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, who can be an employee of the party or an outside agent, as its Cape Town Administrator (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.
There are several important aspects to the Treaty’s application, many of which were covered in our first article, such as Assignments, Novations, Leases, Amendments, and treatment of Helicopter Engines. We have not included these topics in this year’s article, but refer the reader to last year’s article for information on these subjects.
The Right to Discharge
The “Right to Discharge” is a relatively new concept under the Treaty and one that remains somewhat of a mystery to the industry. 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 (a TUE account must be renewed annually to remain in effect), 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 to 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 transfer the RTD for 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 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.
Generation II is a complete redesign of the IR website, intended to make the website more user-friendly and enhance several features of the website. Two of the most important enhancements of Generation II are (i) Multiple Object Registrations (“MOR”), and (ii) Multiple Object Search (“MOS”).
At its inception the IR website only allowed users to complete one registration at a time. As one can imagine, when faced with a multiple collateral transaction (for instance twenty aircraft with two engines each = 60 aircraft objects) requiring multiple registrations (a security agreement, bill of sale, lease and lease assignment = 240 registrations), completing such registrations took days and sometimes weeks. The IR was cognizant of this fact and has addressed this issue through Generation II and MOR. MOR allow a user to load multiple pieces of equipment into a list and complete the same registration against all of the aircraft objects in the list. For instance, if a security agreement covers twenty aircraft and associated engines, the user can now load each aircraft and engine into a list, select the debtor and creditor and complete the registration of the related international interest against all twenty aircraft and associated engines at the same time. Though MOR have helped tremendously in cutting down the amount of time it takes to complete registrations on multiple collateral transactions, it still takes the user quite a bit of time, as each aircraft object must be loaded into the list individually. Also, the MOR function does not allow a user to complete discharges of interests; a user still has to discharge each interest individually.
Similarly, at its inception the IR website only allowed users to obtain one Priority Search Certificate at a time. Again, when faced with transactions involving multiple pieces of collateral, obtaining all the Priority Search Certificates from the IR website was a time-intensive task. The MOS function now allows a user to search for and create a list of all the Priority Search Certificates required and obtain all of them at once.
The September 2013 launch of Generation II was just the beginning of many new functions and enhancements of the IR website. The most interesting new function of the IR website will be the Closing Room. While the regulations covering how the Closing Room will function are still in process, we do have a general understanding of how this new feature will work. The purpose of the Closing Room is to allow users to pre-position registrations and, in the case of transactions involving multiple registrations on multiple pieces of equipment, establish the chronological order of such registrations. The user which establishes the Closing Room is the Coordinating Entity, and the Coordinating Entity will be responsible for assembling and managing all the information required to pre-position the registrations and the order of such registrations. Once the Coordinating Entity has inputted all the information into the Closing Room, each of the parties (TUEs) to the registrations will have the opportunity to review the registrations and provide its consent; however, at this time it is envisioned that only the Coordinating Entity will be able to make changes to the registrations contained in the Closing Room. Once the transaction has closed and the parties are ready to complete the registrations, the Coordinating Entity will send a Release Instruction to the IR requesting that the pre-positioned registrations in the Closing Room be entered into the IR database in the chronological order set forth in the Closing Room. Though an exact date for the release of this upgrade has not been set, it will be a big change to the way registrations are currently preformed.
For many practitioners, the Treaty is not a daily part of business. So, it is not easy to sort through the Treaty provisions to determine the process undertaken in connection with a transaction covered by the Treaty. Below is a brief summary of the basic steps taken in connection with such a transaction:
- Determine if the equipment is large enough to fall under the Treaty (consult the type certificate data sheet).
- Identify all entities that are parties to the transaction documents.
- Determine what parties are “situated” in a Contracting State and the country of registration of the aircraft.
- Review the transaction documents to determine what international interests, or assignments thereof, are created: security agreement, conditional sale agreement, lease, sale, prospective sale, subordination, discharge.
- Establish an IR account for each party creating or benefiting from an IR registration (a TUE). Each party must designate a person who will be the “Cape Town Administrator” for the party. The Administrator should be someone familiar with the Treaty and IR functions (and does not need to be an employee of the party).
- Identify a professional user entity (PUE) that will make the necessary registrations at closing. The PUE will electronically request consent from the Administrator of each TUE for each piece of equipment involved, and the Administrator must electronically consent to such request. If the Administrator is an agent of the TUE (not an employee), then a responsible person with the TUE must authorize the Administrator to consent.
- At closing, all parties will provide the PUE with signed copies of the transaction documents (to comply with the “writing” requirement of the Treaty). The parties will then direct the PUE to make the required registrations on behalf of all parties. Upon completion of the registrations, the PUE will obtain post-closing priority search certificates from the IR which certificates evidence the registrations made.
FAA Non-Citizen Trusts
As a yearly update, this article would not be complete without an overview of the recent Notice of Proposed Policy Clarification for the Registration of Aircraft to U.S. Citizen Trustees in Situations involving Non-U.S. Citizen Trustors and Beneficiaries [published in the Federal Register on February 9, 2012 (77 FR 6694)] and Notice of Policy Clarification for the Registration of Aircraft to U.S. Citizen Trustees in Situations involving Non-U.S. Citizen Trustors and Beneficiaries [published in the Federal Register on June 18, 2013 (78 FR 36412)] (the “Clarification”).
Unlike most countries, the United States civil aircraft registry is an owner registry, instead of an operator registry. Thus, aircraft registered with the FAA are registered in the name of the legal owner, and such owner must qualify as a United States citizen as defined by the FAA (essentially, a majority of the ownership interests and management must be vested in United States citizens). For decades, the FAA federal regulations have contained provisions allowing the use of owner trustees to hold legal title to aircraft for the benefit of a trustor under a written trust agreement. The trustor can be a United States citizen or a non-US citizen (hence a non-citizen trust “NCT”). The NCT is an incredibly useful tool for the aircraft industry worldwide: NCTs allow non-US citizens to invest in aircraft, utilise aircraft more fully, obtain FAA-approved maintenance and conversion work, provide a base for aircraft moving to a new lessee or undergoing repossession – to name just a few.
In 2010, the FAA began a comprehensive review of the use of NCTs, based on three concerns: (i) FAA oversight of FAA-registered aircraft in accord with national and international law; (ii) whether the use of NCTs were within the regulatory framework provided by FAA regulations; and (iii) whether the FAA could obtain information about the operation, management and maintenance of aircraft held in NCTs. The FAA’s review included public meetings and intense collaboration and communication with the aircraft industry. During the process, it was unclear where the FAA would end up, with the worse-case scenario being that NCTs would be abolished. The FAA review culminated in the Clarification, which benefits the FAA by providing processes to obtain information about an aircraft, its operations and records, provides clear guidance to the industry for compliance with FAA regulations on NCTs, and reinforces the FAA’s acceptance of this registration vehicle. Issuance of the Clarification is a concrete example of government action at its finest – the FAA saw inadequacies in the use of NCTs, studied the issue, obtained public comment, and instituted change that fulfilled the FAA’s needs and re-enforced acceptance of the NCT as a valuable registration vehicle for the aircraft industry.
The Clarification contains suggested changes to the standard form owner trust agreement, which changes have been universally adopted by the industry. Those changes include the following:
- Aircraft Information. Trust agreements now contain information the FAA may seek from an owner trustee in relation to an aircraft under trust, and timelines by which the owner trustee should provide such information to the FAA. Similar provisions are contained in standard form trust agreements whereby the trustor agrees to provide such information to the owner trustee and consents to the dissemination of such information by the owner trustee to the FAA.
- Instruments Affecting a Legal Relationship under the Trust Agreement. The Clarification requires that the trustee state what documents, other than those filed with the FAA, affect a legal relationship under the trust. Specifically, the Clarification focuses on whether an operating agreement will be executed between the trustee and the trustor and, if so, the operating agreement must be submitted to the FAA along with the trust and title documents. The reason for the requirement is because the FAA regulations require that all instruments legally affecting a relationship under a trust be submitted to the FAA. In the Clarification, the FAA makes it clear that an operating agreement necessarily affects such relationship and, thus, must be filed with the FAA as a part of the registration process. Parties may choose to have the FAA return the operating agreement after processing the title documents. If not returned, then the operating agreement is made a part of the FAA trust file. The operating agreement may also be filed for recording by the FAA and, if so, would be placed in the FAA aircraft file. The trustee’s affidavit of citizenship must now contain a statement as to all documents legally affecting a relationship under the NCT.
- Removal of the Trustee. The owner trust agreement now includes expanded language governing what circumstances a trustor may remove an owner trustee for cause. The Clarification reinforces the regulatory requirement that a trustor holding more than 25% of the power to remove cannot exercise that power. Instead the power to remove must be exercised by an authorised person not under the direct or indirect influence of the trustor. In reality, this means that a non-US citizen trustor holding 100% of the beneficial interest may never remove the trustee regardless of the circumstances. However, the Clarification does not change, alter or prohibit the right of a trustor to terminate the trust at any time for any or no reason.
- ACC Opinion. All trust agreements must be approved by the Aeronautical Center Counsel’s office (“ACC”). If an opinion is not provided to the FAA with the filing of the trust and title transfer documents, then the FAA will forward the filing package to the ACC’s office for review and issuance of its opinion. Thus, it is wise to obtain an opinion prior to the closing of any transaction involving an NCT.
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, ongoing issues and perplexing questions. 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.