The use of traditional leveraged lease transactions for the financing of commercial aircraft has dropped dramatically in the last 5 to 10 years. Due to changes in economic conditions, tax laws, and accounting procedures, there has been very little appetite for equity investors to participate in this type of financing.
The commercial aviation industry, which once relied heavily on such leveraged lease financing, has seen an increase in the utilization of a new structure over recent years involving the use of an orphan Special Purpose Vehicle (SPV) to serve in the role that would traditionally be played by an Owner Trust, in a leveraged lease transaction. We note that the Export-Import Bank of the United States (Exim Bank) was ahead of this curve and has been using orphan structures in commercial aviation finance for 20 or so years, but recently this practice has spread to other areas of commercial aviation finance.
Traditionally, in leveraged lease transactions for the financing of aircraft, rolling stock, and other equipment, an Owner Trust was created by an Equity Investor/Owner Participant and an Owner Trustee. The Owner Trust would purchase the aircraft from the manufacturer and lease it to its end user, the “Lessee” (e.g., an airline or commercial lessor). The funds used by the Owner Trust to purchase the aircraft came from the Equity Investor’s investment in the Owner Trust (typically around 15–20% of the aircraft purchase price) and the proceeds of a loan taken out by the Owner Trust from a Commercial Lender, and secured through a lien placed on the aircraft by the Owner Trust in favor of the Lender.
The Owner Trust would then lease the equipment to the Lessee. The lease payments would be used to pay the principal and interest owed by the Owner Trust to the Lender. After the loan was paid off, the Owner Trust would own the equipment for the benefit of the Equity Investor, free and clear of any debt, liens, or encumbrances. This structure was attractive to Equity Investors for tax purposes, and as an investment, since it would:
- Allow the Equity Investor to be considered to be the Owner of the aircraft, and therefore be allowed to use the tax credits associated with the depreciation of such aircraft;
- Give the Equity Investor an investment return to the extent that the Lease payments exceeded the Owner Trust’s debt obligations; and
- Result in the full ownership of the equipment after the loan was paid in full.
This structure fostered the purchase of new aircraft since such aircraft could be purchased for very little money up front due to the fact that the revenue generated by the aircraft would be used to pay the loan. Lenders were willing to lend into these transactions since (1) the loan payments were calculated in a way that they would be paid off by the rental income generated by the lease of the equipment to the Lessee, and (2) if the loan was not paid, the Lender could force the Owner Trust to lease or sell the aircraft to someone else, or the Lender could take over ownership of the aircraft.
MOVEMENT TOWARD ORPHAN SUBSIDARY STRUCTURES
Although, the leveraged lease structure has not been as attractive to Equity Investors in recent years, there is still a need to provide new equipment financing to airlines, leasing companies and manufacturers of aircraft, which can be paid through revenue generated by such aircraft and which is secured by such aircraft. In order to accommodate this need, the leveraged lease structure has been modified so that it can go forward without the participation of an Equity Investor. Under this new approach, the initial 15–20% is contributed by the potential Lessee seeking to finance the aircraft, rather than by an Equity Investor.
In this structure, a Delaware Limited Liability Company (LLC) or an Owner Trust is created specifically for a particular transaction that acts as owner/lessor/borrower with respect to a given aircraft or aircraft portfolio. (For purposes of this discussion, we’ll focus on the use of an LLC as the registered owner rather than an Owner Trust. However, an Owner Trust certainly can be used. The charitable statutory trust described below would be the Owner Participant of the Owner Trust in such a scenario.) The sole member and manager of that LLC is a newly-created Delaware Statutory Trust (DST). The DST owns 100% of the membership interests of the LLC, and in the DST’s capacity as manager of the LLC, the DST is the party through whom the LLC acts. (A separate LLC and DST is typically created for each loan provided by a Lender. However, multiple aircraft can be financed through the same LLC and DST.) Please see Appendix 1 hereto for a simple diagram charting the Orphan SPV structure.
The DST is created pursuant to a Declaration of Trust entered into by a corporate trustee. Since all trusts need to have a beneficiary, the DST is created for the benefit of an IRS-approved charity (a non-tax-paying entity). Under the terms of the Declaration of Trust, the charitable Beneficiary will be entitled to any funds or other property which are distributed by the LLC to the DST by reason of its membership interest in the LLC. However, under the terms of the LLC Agreement, there can be no distribution to any member of the LLC by reason of such membership interest until the LLC has satisfied all of its obligations under a given set of Operative Documents, including payment in full of any loans taken out by the LLC. The LLC then leases the aircraft to the Lessee. The Lessee’s lease payments are calculated to match the LLC’s loan payment obligations under the Loan Agreement. (It is important that the rental fees equal the loan payments each year, so that the LLC will not be deemed to have any income from the Lease.) After the loan is paid off, the LLC transfers ownership of the Aircraft to the Lessee (usually for a nominal fee).
In order to secure the loan payments, a security interest in the aircraft is pledged to the Lender and the DST’s membership interest in the LLC is also pledged to the Lender. In the event of a Loan Default, the Lender has the right to repossess the aircraft from the LLC, or it can take ownership of the LLC and cause the LLC to lease the aircraft to a different Lessee. By effecting the transfer at the LLC membership level, the aircraft does not need to be re-registered since the owner continues to be the LLC. In connection with the operation of the LLC and the administration of the transaction (until the loan has been satisfied), the member and manager look to the Lender for direction in connection with issues that are not specifically addressed, or otherwise provided for, in the Operative Documents. Such events are usually limited to amendments, consents, or requests that are delivered to the LLC for execution throughout the course of the transaction. In practice, this does not in any way inhibit or hinder the Lessee’s proper use of the aircraft.
In summary, the benefits of the orphan subsidiary structure for the financing of commercial aircraft include the following:
- Use of the familiar leveraged lease financing approach, without the need for an Equity Investor;
- Protection of the Lender’s interest in the aircraft;
- Transfer of equipment ownership, after loan payoff, to the Lessee; and
- Viable alternative for non-tax-driven transactions.
While the discussion above focused on the use of an Orphan SPV in commercial aviation finance, this structure could be applied to financings of any class of asset which generates a predictable revenue stream.