Buying and Operating Business Aircraft in the Current Economic Environment
The business aviation community has been dramatically affected by the current economic downturn, tight credit market and negative publicity associated with use of corporate jets by executives of some companies. With low demand, inventories of aircraft have risen and prices have fallen, creating a strong buyer’s market. However, this stressed market makes aircraft transactions more challenging. This article provides useful information to help avoid problems in purchasing and operating business aircraft.
Business Aircraft Transactions
The market for new and used business aircraft had been very strong over the last few years, with demand outstripping the availability of new aircraft. In the past, transactions often moved quickly – once a signed letter of intent was obtained, there was probably a 95 percent chance the deal would go through without a hitch. However, the dramatic market changes and tightening of credit markets have not only slowed transactions, but have significantly increased the number of deals that fall apart, and in some cases wind up in court.
In the last few months, problems have arisen which affect a wide range of transactions, such as:
- last minute liens placed on aircraft by unpaid vendors, who get wind of an impending sale
- dissolution of entities
- aircraft being properly or improperly used as cross collateral for general business obligations
- one manufacturer declaring bankruptcy, leaving buyers as unsecured creditors
- a rise in fraud
In this strained environment, the risks of a problem or even fraud arising in a transaction are increased, and the days of loosely “papering” the transaction are over. The following are a few recommendations.
Properly Paper the Transaction
Having the deal properly documented by a competent aviation attorney is critical for both buyer and seller. For example, some issues to consider are:
- The default and termination sections deserve particular attention, as a seller who loses a deal in this market may suffer significant economic harm. There has certainly been an uptick in litigation over transactions that have gone bad.
- Buyers should include a financing contingency clause because many deals for older aircraft are extremely difficult to finance.
- Beware of clouded title. Often the warranty of good title is given by a special purpose entity whose only asset is the aircraft. There are several ways to mitigate against this: title insurance, legal opinions, or requesting a warranty of good title from the beneficial owner.
- In international transactions, there are specific issues with export certificates of airworthiness, export and embargo restrictions, and export clearance procedures that must be followed.
Don’t Take Short Cuts in Your Diligence
In a stressed market, extra diligence is warranted:
- Aircraft Inspection. As the buyer, you will want to have a through inspection and records review by an inspection facility familiar with the aircraft type and its problems. With companies in financial distress, maintenance and preservation may be skimped on, and “pencil whipped” records may be a possibility.
- Lien Searches. An FAA title search should be done at the Letter of Intent stage and right before closing, as last minute liens placed on aircraft just before closing by vendors who get wind of an impending sale are known to happen. Similarly, if the seller is in financial distress, additional searches for UCC filings, tax liens, etc., may be warranted.
- Be Alert for Scams. There are at least two active fraud scams running and, given the dollars involved in aircraft transactions, there may be more in the future. The escrow fee scam involves a bogus foreign buyer represented through a broker. The deal calls for the buyer’s deposit to be placed, at least initially, in escrow with an entity in the UK, and for the parties to split escrow fees evenly. The scam involves the seemingly independent escrow agent asking for half the escrow fees paid up-front. Furthermore, the cashier’s check scam is apparently back. This involves an apparent buyer who will pay by cashier’s check, but makes the check out for more than the purchase price/deposit. They then ask for the remainder to be wired back to them.
Who Does the Broker or Consultant Represent?
In this fluid pricing environment, a reputable aircraft broker services is essential to get the best price for aircraft, to spot problems or scams, and help move the transaction forward. However, it is imperative to be sure (i) the broker (or lawyer, or any other consultant for that matter) is representing your exclusive interests, and (ii) that the relationship is documented in a written agreement.
- A buyer’s broker should disclose if he or she is representing the seller or is receiving other remuneration from third parties. The same concerns arise if one is using their own pilots or management company to locate and negotiate for an aircraft.
- Beware of “back-to-back” transactions. In a “back-to-back” transaction, a broker agrees to sell an aircraft that he or she doesn’t own to a buyer, and then arranges to buy that aircraft from the true owner for a significantly lower price. The broker never puts up any money but uses the buyer’s money to purchase the aircraft and immediately transfer title to the buyer, with the broker pocketing the difference (which may be significant). In addition to higher costs to the buyer, such transactions can create title problems and other concerns, particularly if the deal goes bad.
- Another concerning practice can occur with trade-ins. A broker may agree to buy an aircraft (or find a buyer) at a seemingly excellent price provided that the seller buy another aircraft at a certain price. In reality, the broker may simply have jacked-up both aircraft prices so that the brokerage fee will be higher on both aircraft.
Structuring Your Ownership/Operations
Although the core structuring considerations remain unchanged, this economic environment calls for special attention to the timing of transactions, relationships with third parties, financing concerns and alternative structures.
Core Structuring Issues
- Tax Considerations. The corporate structure and operations should maximize the owner’s ability to depreciate the asset, minimize the impact of state sales and use tax, and minimize the impact of personal and entertainment use.
- FAA Compliance. Unless the aircraft is managed by an FAA certificated charter operator, there are strict limits on when a company can be reimbursed by another person for provision of air transportation. In particular, the use of special purpose “flight department” companies to own and operate an aircraft generally violates FAA regulations.
- Liability Mitigation. Ownership and operation should be structured to minimize the liability exposure of the company and its principals. This is done through structuring, adherence to corporate formalities and insurance coverage.
Timing of Transactions for Tax Purposes
- Tax Free Exchanges. If a transaction is planned as a tax-free exchange under IRS Section 1031, it is important to plan well ahead, as selling the current aircraft may take many months. In addition, if significant funds or aircraft title will be “parked” with a qualified intermediary (QI), choose that intermediary with care, as at least one QI specializing in real estate has gone bankrupt, not only potentially spoiling the exchange, but putting funds at risk. In addition, know where the QI will park funds, as some QIs in the past invested this money in the market to earn higher returns.
- Bonus Depreciation. The economic stimulus legislation passed in mid-February 2009 extends bonus depreciation for new aircraft purchased in 2009. This may make positions for deliveries in 2009 and 2010 significantly more attractive for buyers who can take full advantage of bonus depreciation.
Relationships With Managers and Other Vendors
Many charter management companies, vendors and even some manufacturers are struggling in the current market. Given the dollar amounts involved in operating large business jets, an owner may have significant dollars tied up with these vendors. In fact, one charter manager’s failure to pay vendors led to liens being placed on managed aircraft, as well as delayed lease payments for the owner’s percentage of charter revenue. Some suggestions for mitigating risk with a charter manager are:
- The operating account could be set up as an owner account, in which the charter manager has rights to withdraw or, alternatively, as a separate manager account in which the owner has a security interest.
- Owners may wish to directly pay certain vendors, rather than pay them through the manager (e.g., insurance and engine maintenance program payments).
- Ensure that the owner rather than the charter operator is the party to the relevant vendor agreement, where practicable.
- Negotiate adequate triggers of charter operator default, such as liens, not in the ordinary course of business, etc., so that termination can be effected quickly if necessary.
Given the tight credit market, it is important to work on financing early. Financing is available for companies with good credit buying newer aircraft. Some considerations:
- 100% financing and limited recourse financing are likely unavailable.
- Loans may be easier to obtain from a financial institution with which the buyer has existing financial relationships, as banks are less interested in orphan transactions.
- Traditional loans may be difficult to obtain on older aircraft.
- Consider alternative financing, such as seller financing, or use of conditional sales agreements.
Since money is tight and many corporate aircraft are currently underutilized due to the current public perception of corporate aviation, buyers and owners should consider alterative arrangement such as:
- Sale and Leaseback. For companies that own their aircraft outright, a sale of the aircraft to and leaseback from a financial institution may be a viable way to generate capital and take an aircraft off the books.
- Dry Leasing. Buyers may find opportunities to lease aircraft at substantially less than the cost of ownership from existing owners who cannot sell their aircraft.
- Joint Ownership. For underutilized aircraft, joint ownership helps spread the cost of ownership.
In summary, while this stressed market provides numerous business opportunities, aircraft owners and prospective buyers must exercise additional due diligence with their aircraft transactions and relationships with vendors.