Judicial clarification of the choice of law rules for aircraft mortgages: how a mortgage may be effective in one jurisdiction but ineffective in another

April 2010

Contacts

Summary

The English High Court has recently held that:

  • it is the lex situs (that is, the laws of the jurisdiction where the relevant asset is situated at the time that the interest is created) which determines whether a property interest, such as a mortgage, is effectively created over that asset;
  • if the asset is capable of registration and is registered in a different jurisdiction to the lex situs, a mortgage which is valid under the laws of the state of registration but invalid under the domestic laws of the lex situs jurisdiction will be ineffective in England;
  • English law will look only to the domestic laws of the lex situs jurisdiction without reference to its conflict of laws rules in deciding the issue of validity of a mortgage.

The decision will have an impact on how mortgage security in relation to aircraft financing transactions is structured and is of particular importance to banks seeking to establish, for Basel 2 purposes, that they have legally enforceable and effective security over an asset which is enforceable in every relevant jurisdiction.

Background and Facts

The English High Court considered the principles and issues involved in deciding the validity of mortgages over, and transfer of title to, tangible moveable property such as aircraft in the case of Blue Sky One Limited & O’rs v Mahan Air & Ano’r [2010] EWHC 631 (Comm).

The full facts of the case are complicated and relate to several Boeing 747-422 aircraft. The background of the case is the consequences of sanctions imposed by the United States prohibiting the export of certain assets into Iran. This briefing limits itself to consideration of the case insofar as it impacts on the issue of the effectiveness of aircraft mortgages.

One of the aircraft was owned by an English special purpose company (SPC). It was leased to an Armenian company, Blue Airways LLC, registered with the Armenian Civil Aviation Authority, and then chartered to Mahan Air, an Iranian company. The SPC subsequently mortgaged the aircraft in favour of PK Airfinance US Inc. (PK) at a time when the aircraft was physically situated in the Netherlands. The mortgage was expressed to be governed by English law. The SPC and PK were unable to repossess the aircraft.

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The Decision

One of the issues on which the court was asked to adjudicate was whether the mortgage was sufficient to create a proprietary interest over the aircraft in favour of PK. The court heard expert evidence as to whether the English law mortgage would be upheld under the domestic laws of each relevant jurisdiction and decided that the mortgage would be:

  1. valid if the laws of England or Armenia were the proper laws applicable to it; but
  2. invalid if the laws of the Netherlands were the applicable proper laws because a Dutch court will only recognise a mortgage created under the laws of the state of registration (i.e. Armenia).

The Court then considered what English law would treat as being the mortgage’s proper law.

Some commentators have in the past suggested that aircraft should be treated differently from other tangible moveable assets on account of their international nature and their possibly rather arbitrary location at any relevant time. The argument has been that property rights over them should be accepted if constituted under the laws of their state of registration. The court, however, did not accept this argument, refusing to distinguish aircraft from other chattels and applying the pure lex situs rule. Mr Justice Beatson therefore held that the validity of the mortgage would be determined by Dutch law because the aircraft was physically situated in the Netherlands at the time that the mortgage was created.

The court continued to consider the validity of the mortgage under Dutch law. If it had taken account of the principles of Dutch private international law, then the court might have held that:

  1. Dutch law required the mortgage to be valid under the laws of the state of registration, that is Armenia; and
  2. an Armenian court would uphold the choice of English law to govern the mortgage;
  3. so, using the legal referral system known as renvoi, an English court should also uphold this choice of law.

However, the court actually held that, when deciding on the validity of the mortgage under its proper law, it was necessary to look only to the domestic law of the lex situs jurisdiction and ignore its conflict of laws rules. It held that the concept of renvoi did not apply when considering the proper law for the creation of property rights over tangible moveable assets. As the mortgage would be invalid under domestic Dutch law, the English court would not give effect to it, even though a Dutch court would uphold it under its own conflict rules.

The only exceptions to this rule are:

  1. where the location of the asset is genuinely unascertainable (as was the case with one of the other aircraft the subject of the litigation), in which case the court held that the parties have freedom to choose the law to govern these matters (and so upheld the validity of an English law mortgage over that aircraft); and
  2. where an aircraft is in flight in international airspace, in which event authority suggests that it may be deemed to be situated in its state of registration (Dicey and Morris, Rule 120, Exception 2).

This decision, insofar as it relates specifically to aircraft, is not consistent with the rules set out in the two principal international conventions in this field. The Geneva Convention privileges the law of the State of Registration for perfecting property rights over aircraft and the Cape Town Convention by its terms sets out how these may be created without reference to any national legal system. However, the judgment will have persuasive authority in several jurisdictions (including many tax havens commonly used in aircraft finance) which have not ratified either convention.

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Practical Consequences

Mortgages over aircraft registered outside the United Kingdom may continue to be expressed to be governed by English law but, following this decision, it is clear that, in order for such mortgage to be recognised by an English court, either:

  • it must be effective under the laws of the jurisdiction where the aircraft is located at the time of its creation, without regard to the conflict of laws rules of that jurisdiction; or
  • the aircraft must be in England at the time that the mortgage is executed.

On the basis of existing authority, the courts will not give effect to an English law mortgage over an aircraft registered outside of the United Kingdom if the aircraft is in international airspace at the relevant time.

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Conclusion

In many jurisdictions, such as Netherlands and France, local domestic laws will only recognise the validity of a mortgage if constituted under the laws of the state of registration of the aircraft.

If an aircraft is physically located in such a jurisdiction but registered elsewhere, it will be impossible to obtain a mortgage over the aircraft that will be recognised both by an English court and by a court of the lex situs jurisdiction.

It may be advisable to arrange for the mortgage to be created whilst the aircraft is physically situated in the state of registration. This may be achieved by flying the aircraft to its state of registration before the mortgage is executed but will mean that the lenders may be effectively unsecured before the mortgage is executed.

In addition, banks should be aware that an English law mortgage taken over an aircraft with no physical or other legal link to England may well be completely ineffective in most, if not all, jurisdictions.

Different considerations will apply when structuring security over aircraft which are covered by the Cape Town Convention.

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