Does an operating lessee have to pay rent for a defective aircraft?

May 2010

Aircraft engine

Contacts

Introduction

In ACG Acquisition XX LLC v Olympic Airlines S.A. [2010] EWHC 923 (Comm.), the English High Court was asked to rule on the circumstances in which the defective condition of an aircraft delivered to an airline under an operating lease might entitle the airline to refuse to pay rent for it. It raises important issues both on substantive law (on the issue of what is meant by a “total failure of consideration”) and on the way in which operating leases are drafted.

Facts

In 2008, ACG Acquisition XX LLC (Lessor) entered into an operating lease (the Olympic Lease) with Olympic Airlines SA (Lessee) under which it agreed to lease a Boeing 737 aircraft for a term of five years. The Lessor undertook that the aircraft would be airworthy and in a condition suitable for immediate operation in commercial service and that it would comply with the detailed requirements specified in the lease as to the condition of the aircraft on delivery (Delivery Condition).

The aircraft was delivered on 19th August 2008. The Lessee signed a Certificate of Acceptance, which, under the Olympic Lease, was formally deemed to constitute delivery. The aircraft then went into service on 23rd August 2008. The Hellenic Civil Aviation Authority (the CAA) duly became the competent authority for the aircraft and granted the aircraft a Certificate of Airworthiness.

On 6th September 2008, just 15 days after it entered into service, the aircraft was grounded when broken cables that controlled the spoilers on one wing were found. While trying to repair the broken cables, the Lessee discovered 14 separate categories of defects, including defects which affected other flight control surface mechanisms such as the ailerons. The state of the aircraft was such that, on 11th September, 2008, the CAA took the step of withdrawing the aircraft’s Certificate of Airworthiness. Even after the aircraft had spent months at Europe Aviation, a maintenance and repair organisation (MRO) nominated by the Lessor, the CAA still refused to grant it a Certificate of Airworthiness. The Lessee claimed that the cost of the work which would be required to render the aircraft airworthy would exceed the value of the aircraft and this claim was not challenged by the Lessor.

The Lessee claimed that it was under no obligation to pay rent, there having been a total failure of consideration. Alternatively it claimed that it was entitled to counterclaim substantial damages (including in respect of its liability to pay rent) which would more than extinguish its rental obligations. The Lessor responded that the terms of the lease, and, in particular, the acceptance certificate executed by the Lessee, precluded it from making any claim in respect of the aircraft’s delivery condition or to set off any amounts against the rental, which remained payable in full. The Lessor applied for summary judgment.

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The decision

The court dismissed the Lessor’s application for summary judgment, holding that the Lessee had established an arguable case that:

  1. the failure by the aircraft to comply with the Delivery Condition was such as to place the Lessor in breach of contract allowing the Lessee to claim damages, notwithstanding the “as is, where is” language, the standard disclaimer of liability and waiver of rights and the terms of the Acceptance Certificate;
  2. the aircraft was in such a bad condition at Delivery that there had been a complete failure of consideration; and
  3. the hell and high water clause (which provided, in summary, that the Lessee’s obligation to pay rent was absolute and unconditional irrespective of any right of set-off or any defect in the airworthiness of the aircraft) was ineffective to prevent the court ordering a stay of execution of any successful claim brought by the Lessor for the unpaid rental pending the resolution of the Lessee’s counterclaim.
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Consequences

This was a claim for summary judgment and the judge only held that the Lessee had established a case to answer. The full trial will be heard later this year. However, much of the judge’s reasoning was unequivocally in the Lessee’s favour.

It will be necessary to wait for the full trial for a clearer idea of just how deficient the aircraft must be from its required Delivery Condition for there to be a “total failure of consideration”. This case was quite extreme if the Lessee was correct in stating that the cost of the aircraft’s repair would exceed its market value.

Delivery Process

Most operating (and, indeed, finance) leases are drafted on an “as is” basis, placing the onus on the lessee to verify the satisfactory condition of the aircraft before delivery and then leaving it with the risk of rectifying any subsequently discovered defects. This case questions to what degree that procedure is effective. However, there are certain lessons that can be learned from the judgment as to how operating leases should be drafted and implemented so as best to protect operating lessors.

  • The Olympic Lease provided that the lessor would deliver the aircraft “as is, where is” and in the condition required in the relevant schedule. This is an apparent contradiction in terms since “as is” means in the condition which the aircraft happens to be at the time. The court held that this imposed a positive obligation on the lessor to deliver the aircraft in a particular condition and that the lessor was in breach of that obligation.
  • Usually, the obligation of the lessee to take the aircraft on lease is subject to the condition precedent that the aircraft is in the required delivery condition. If, at Delivery, the aircraft is not in the required condition, the lessee may reject it or agree a “snag” list of matters that need to be remedied by the lessor post-delivery. The mechanism for agreement of the contents of that snag list needs to be agreed in the lease. Subject to the agreed snags, any defects found post-Delivery should be for the lessee’s account.
  • Note that the Delivery Condition, being a condition precedent and not an undertaking, should be drafted as a state of affairs, which if true, bind the lessee to accept the aircraft and not as a mandatory requirement which might be interpreted as imposing a continuing obligation on one or other party.

Inspection

In the Olympic Lease, the Lessee’s ability to inspect the Aircraft before Delivery had been restricted. It was only allowed to carry out external inspections on four different occasions. It was not allowed to open parts of the aircraft, inspect and/or test internal parts of the aircraft or run diagnostics save in relation to the engines. The technical records supplied to the Lessee “painted a falsely reassuring picture and recorded work which had not been carried out adequately, if at all”. The Lessee claimed (although this was disputed by the Lessor) that many of the defects which led to the aircraft being taken out of service had actually been notified to the Lessor before the lease commenced and were certified prior to delivery as having been rectified, but evidently had not been. These facts increased bolstered the Lessee’s claim that there had been a total failure of consideration.

  • The pre-delivery testing and inspection procedures should be clearly set out in operating leases. It is important that these procedures be strictly adhered to.
  • The Lessee should confirm in the acceptance certificate that the procedures have been followed or that any deviations to those procedures are satisfactory to it.
  • The procedures for agreeing a list of defects need to be clearly documented and adhered to.

Further drafting issues

The Olympic Lease contained the exclusions and disclaimers of liability, “as is, where is” and hell and high waters clauses which are usually found the in operating leases and which are intended to be protective of the lessor in this situation: however, the way in which the clauses had been negotiated subordinated these clauses to the overriding obligation of the Lessor to deliver the Aircraft to the Lessee in the Delivery Condition.

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Conclusion

This case emphasises the importance of taking care when negotiating operating leases so that the commercial intent - that the aircraft be delivered in “as is” condition - is not overridden by final signed document.

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