This legal update
highlights the most relevant recent regulatory initiatives, new implications of long-standing legislation and published commercial law opinions, all relating to rail, marine or aircraft financings during the past year. Among other things, this article discusses a controversial new rule authorizing the use of certain rail assets, bankruptcy restructuring considerations for vessel financiers, and regulatory and case law developments that should be of interest to aircraft financing providers.
RAIL FINANCE UPDATE
Liquified Natural Gas Transportation
The U.S. Department of Transportation and U.S. Pipeline and Hazardous Material Safety Administration, in consultation with the Federal Railroad Administration, authorized rail shipping of liquefied natural gas (LNG), effective as of Aug. 24, 2020. Previously, federal hazardous materials regulations allowed shipments of LNG by truck, but not by rail, except with a special permit. The rule had been opposed by environmental groups and 15 states, because of the risks of derailment, spill and explosion.
The new rule requires enhanced outer tank requirements (thicker steel outer tanks with greater puncture resistance) and additional operational controls for carrying LNG, such as remote monitoring of pressure and location of LNG tank cars.
On Aug. 18, 2020, 14 states and the District of Columbia filed a lawsuit against the DOT in the Court of Appeals for the District of Columbia Circuit challenging the new rule.
Jones Act and Maritime Bankruptcies
VESSEL FINANCE UPDATE
Recent bankruptcies of U.S. maritime companies, especially in the offshore sector, have transformed some lenders and lessors from creditors to holders of equity in the reorganized companies. This change of status potentially subjects these financial institution former creditors to the comprehensive citizenship requirements of the Jones Act—the laws regarding the operation of vessels in the United States.
The Jones Act requires that owners and operators of vessels (but not lenders or so-called foreign lessors) have at least 75% of their equity owned and controlled by “U.S. citizens.” In this context, “U.S. citizens” generally means entities that are organized in the U.S., have certain officers and directors who are U.S. citizens, and have 75% of their equity owned and controlled by U.S. citizens. When Jones Act vessel owners and operators are reorganized in bankruptcy, the reorganized entity needs enough U.S. citizen creditors to become shareholders to ensure compliance with the 75% test. Creditors that either do not qualify as Jones Act citizens or cannot substantiate their U.S. citizenship to the satisfaction of the reorganized company may, nonetheless, receive a portion of their allowed claim in (a) shares in the reorganized company, as long as all shares held by non-citizens do not exceed 25% of the reorganized entity’s shares, or (b) warrants in the reorganized company. While warrants give the holder the right to purchase shares, the U.S. maritime regulatory agencies, namely the Coast Guard and the Maritime Administration, do not treat warrants as equity prior to conversion into shares as long as the holders of warrants do not have shareholder rights, such as voting rights and receipt of dividends.
Reorganized Jones Act companies usually require detailed evidence of citizenship before allowing creditors to hold shares as U.S. citizens. This can be a burdensome process for public companies.
In addition, companies reorganized in bankruptcy typically restate their organizational documents to include provisions to ensure continued compliance with the Jones Act, including restrictions on the transfer of shares to non-citizens and provisions to safeguard the company’s Jones Act eligibility should the percentage of shares held by U.S. citizens fall below the required 75%, including voiding transfers or not treating transferees as shareholders.
The Jones Act requirements are always in effect. Creditors that decide to take shares as U.S. citizens should periodically diligence their citizenship status to ensure continued eligibility.
AIRCRAFT FINANCE UPDATE
FAA Registry Risks: Addressed or Created?
The U.S. Government Accountability Office issued a report in May 2020 recommending changes to FAA Registry practices to address law enforcement, sanction compliance, anti-terrorism, and safety risks. Among the recommendations are that the FAA collect, record, verify and make accessible in electronic format, much more detailed information regarding individual and certain private legal entity registrants, and subject to greater scrutiny “opaque” structural devices such as SPEs and trusts, as primary risk indicators of Registry fraud and abuse. These recommendations, if implemented, could cause Registry use to be more laborious, protracted and expensive, create certain privacy and security risks, unduly restrict common transaction structures and result in registration validity challenges.
OFAC Sanctions: Great Expectations.
An aircraft lessor paid a civil penalty to OFAC for alleged sanctions violations related to two engines that were leased to a UAE lessee, subleased to a Ukrainian airline and then wet leased to Sudan Airways. Because Sudan Airways was on OFAC’s Specially Designated Nationals and Blocked Persons List, OFAC deemed the lessor to have violated the sanctions regulations by dealing in property or interests of the Sudanese government, and exporting goods to Sudan. OFAC levied the sanction even though the lease prohibited this conduct, and the lessor terminated the leases, noting that it is important that “companies operating in high-risk industries implement effective, thorough and on-going, risk-based compliance measures, especially when engaging in transactions concerning the aviation industry.” Essentially, the lessor was held strictly accountable for not ensuring compliance by its lessees and sublessees, so lessors must take active ongoing measures to detect and avoid violations.
A few cases. Reish, et al., v. Mukai, No. CV-19-00400-PHX-DLR, 2019 BL 456414 (D. Ariz. Nov. 25, 2019).
An appellate court upheld a bankruptcy court’s conclusion that the purchase of a helicopter was avoidable under the Bankruptcy Code because the buyer failed to record its interest on the FAA Registry prior to the seller declaring bankruptcy, and federal law preempts state commercial law regarding recognition of interests in the context of a bankruptcy Federal law takes precedent over state law regarding title and lien issues relative to 3rd parties.
Wells Fargo Tr. Co., N.A. v. Synergy Grp. Corp., 18 Civ. 11151 (LGS), 2020 U.S. Dist. LEXIS 100751 (S.D.N.Y. June 9, 2020).
The Court ruled that a liquidated damages formula in a commercial aircraft lease providing for payment of the present value of future payments, reduced by disposition proceeds, was not punitive to the lessee but instead allowed the engine lessor to achieve the benefit of its bargain, and that return deficiency damages were an appropriate “risk allocation” because they were expressly agreed to. Unlike the Republic decision (In re Republic Airways Holdings Inc., 598 B.R. 118 (Bankr. S.D.N.Y. Feb. 14, 2019)), this Court cited post-UCC § 2A-504 and current guaranty precedent, respecting freedom of contract principles, especially the ability of sophisticated parties to allocate risks and adjust pricing to reflect that allocation.
Peyton Holdings, LLC v. Clover Aviation Co., 2020 U.S. Dist. LEXIS 131527 (S.D.N.Y. July 24, 2020).
The Court upheld lease “hell or high water” clause and lessor’s unpaid rent claim, but not its claim for accelerated damages, because the lease failed to include an acceleration remedy. Lessor could still have pursued accelerated rent damages under the statutory remedies in UCC 2A, but failed to do so; but EL&F readers know better.
Given the wide spectrum of state, federal and international legal considerations when financing rail, marine and aircraft assets, participants in those financings must not only be and remain aware of prospective or existing changes in those laws, but also must consider how best to conform their transactional practices and policies when entering into and managing rail, marine and aircraft financings.