Air Transport Industry Group
AD Cost Sharing Provisions in Aircraft Operating Leases
Published in Airfinance Journal-Guide to aviation lawyers 2002
Controlling operating costs is essential in any business. Unlike most other industries, aircraft owners and operators face large, sometimes tremendous, unplanned springing costs that come in the form of airworthiness directives (ADs) promulgated by the FAA and/or other aviation authorities, service bulletins (SBs) issued by airframe, engine, avionics and parts manufacturers and noise and other environmental regulations. In the past, these costs in the lease context traditionally were passed through to aircraft lessees with little or no cost sharing by lessors. While that approach may have worked when ADs, SBs and other regulations mandating changes to the aircraft were generally few and far between, in a time when, for example, new airworthiness directives are posted daily on the FAA’s website and costs of compliance with ADs, SBs and noise and other regulations can be in the millions of dollars on a per aircraft basis, lessors and lessees typically can be expected to negotiate a more equitable apportionment of the associated costs.
ADs, SBs and Other Regulations.
ADs are airworthiness regulations that direct owners and operators to undertake specific modifications or procedures designed to increase the safety or decrease the risk of operation of an aircraft. So called “mandatory” SBs are, under some regulatory schemes, similar to ADs with the significant difference being that SBs are issued by manufacturers. Common SBs are usually advisory only, typically address maintenance cost and reliability issues unrelated to airworthiness concerns and generally do not carry with them the weight of regulatory authority. Mandatory SBs under the regulatory schemes of some countries are, however, governmentally mandated. Unrelated to airworthiness concerns are governmental regulations requiring modifications to aircraft to comply with environmental issues such as the various noise stages. These differences notwithstanding, implementation of ADs, mandatory SBs and other governmentally mandated changes are generally required of the lessee by the terms of the typical commercial aircraft lease.
Since the 1940s, the FAA has issued ADs which, at the outset, were solely products of government directed intervention in response to government perceived air safety concerns. In recent years, however, manufacturers have increasingly recommended ADs to the FAA in an effort to stem their liability arising from concerns about the safety of their products. It has also been suggested that some manufacturers have requested ADs to be issued where “there was no safety justification but plenty of commercial advantage (like requiring purchase of a replacement part despite a strong safety record behind the original part).” Without regard to the reasons for their issuance, the number of new ADs has sky rocketed in recent years along with the attendant compliance costs. The number of ADs issued by the FAA during the 20 year period from 1982 to 2001 has increased from 282 in 1982 to 949 in 2001, a 336% increase. In addition, the average number of ADs issued by the FAA in each of the past five years is 978 with the annual number of new ADs in each of the past four years representing the highest number of new ADs in the history of their existence. Similar AD inflation has been experienced with other countries’ regulatory authorities. There have been cases in recent years where AD compliance costs (which can generally be broken down into expenses associated with purchasing replacement parts, labor and aircraft down time) on a per aircraft basis have ranged from hundreds of thousands of dollars to over a half million dollars. The magnitude of unanticipated additional expense can potentially be devastating to the operations and profitability of an aircraft operator.
See Busch, Mike. Who Benefits From Airworthiness Directives
Who should bear AD, SB and other regulatory compliance costs for leased aircraft?
The question of how costs associated with AD, SB and other regulatory compliance requiring modification to the aircraft, its engines or parts should be allocated is often a heavily negotiated matter between aircraft lessors and lessees. Typically, aircraft lessors seek to require lessees to bear the entire cost of implementing any AD, mandatory SB or other regulation that arises during the term of the aircraft lease. The lessor’s argument usually is that the risk of ADs, mandatory SBs, etc. are risks of doing business in the airline industry and should be borne by the airline lessee. Alternatively, some lessors agree to share the cost of ADs but not other governmentally mandated changes. Either of these cost allocation models, however, appears to be fundamentally flawed in that the lessee would thereby shoulder the full cost of capital investments in the aircraft but only enjoys its use for the remainder of the lease term. Thus, this negative impact on the lessee, while always disproportionately greater than the benefit received, is more or less acute depending upon the happenstance of the remaining term of the lease at the time when the modification is required to be effected and the magnitude of the cost thereof. Unfortunately, neither the timing nor the cost of most ADs or other governmentally mandated modifications can be predicted.
Although an argument can be made that the lessee should bear some portion of modification cost as a cost of doing business, this argument would appear fairly made only as to costs that under generally accepted principles of cost accounting (or some other means of recognition of economic reality) should be treated as operating costs and not as to costs that should be capitalized. In addition, Lessors also rightly argue that lessees should bear the risks of any regulatory mandated modifications peculiar to any country in which a leased aircraft is operated that are not generally applicable to other areas of the world or the country of its registry. Lessees, on the other hand, sometimes argue that the risk of a major AD, mandatory SB or other governmentally required modification is properly entirely that of the aircraft owner—rather than the operator—as being a risk associated with ownership of this type of capital asset. Lessees point out that the burden of AD costs would in any event be entirely the lessor’s risk if, by chance, the aircraft were not out on lease but in possession of the lessor at the time of required compliance. This argument is probably more persuasive when made in the context of a short-term operating lease but, at bottom, appears no less flawed than a lessor’s position that the lessee should bear the entire risk.
The fact of the matter is that the lessee and the lessor would almost certainly have adjusted their economic deal if, at the time of entering into the lease, both had known that a major modification would be required during the lease term. Thus, the lease mechanic included for sharing such costs when they occur during the term should ideally approximate what a reasonable lessor and lessee would have agreed upon if they had known in advance of entering the lease that the modification would be required to be made during the lease term. It may be assumed that the lessor would pay (or finance) the costs of all such modifications and the rent would be adjusted at the time the cost of the modification is incurred so that the lessor would recoup only that portion of the modification’s cost applicable to the lease term but not the entire cost—which would be spread over the shorter of the remaining useful life of the aircraft or of the modification.
This more equitable alternative is driven by the simple premise that the cost of long term capital improvements in leased property should be shared by the lessee and the lessor in the same proportion as the benefits derived, respectively, by each of them. To achieve this result, the lessor and lessee would agree in the lease that, with respect to each applicable AD, mandatory SB or other governmentally mandated modification, the useful life of each such mandated modification requiring compliance during the lease term will be determined as well as the percentage of such useful life that will occur during the lease term once the mandated corrective action is completed. The percentage so calculated would equal the percentage of costs associated with implementing the AD, SB or other governmentally mandated modification to be borne by the lessee with the lessor responsible for the remainder. When determining the costs to be allocated between the parties based on such percentage share, the full economic costs of the corrective action to the lessee (including aircraft down time) should be included. Through this cost apportionment method each lease party pays its fair share of the attendant modification expenses.
