In December 2015, the Court of Appeal reaffirmed the scope of a mortgagee's duties and to whom such duties are owed. In this briefing we examine the key messages from the decision and the practical implications for the aviation industry.
PK Airfinance Sarl ("PK") financed seven A320 aircraft (the "Aircraft") for Alpstream Aviation Limited and Betastream Ltd (the "Borrowers"). The Aircraft were leased to Blue Wings and the Borrowers granted mortgages over the Aircraft to PK. PK made further loans to Caelus Aviation for an additional three aircraft which were leased to Olympic Airlines (the "Caelus Aircraft"). The mortgages granted over the Caelus Aircraft in favour of PK were cross-collateralised and also secured the amounts owed in respect of the Aircraft. Alpstream's affiliate, Alphastream, had an equity interest in the Caelus Aircraft.
The Borrowers defaulted on the loans in respect of the Aircraft and in March 2010 PK chose to enforce its security. PK repossessed the Aircraft and arranged remedial works to restore them to full life condition then scheduled an auction for the Aircraft to be sold. At the public auction, PK was the only bidder – no third party attended and, although Alpstream did attend, it declined to bid.
Alpstream claimed that PK had breached its duty as mortgagee to obtain the best price for the Aircraft. As a result, Alpstream argued that the equity position of Alphastream was eroded and it would receive less than it deserved from the transaction because there were insufficient sale proceeds to flow through the payment waterfall agreed between the parties.
At first instance the High Court upheld Alpstream's claims and awarded damages representing the difference between the price PK paid for the Aircraft and the price determined by the judge to be the best reasonably obtainable (with reference to an independent valuation).
Court of Appeal decision
(1) No Duty to Unsecured Creditors – the Court of Appeal held that the judge at first instance had overextended the law. A mortgagee owes a duty to the mortgagor and those with an interest in the 'equity of redemption' (including subsequent mortgagees, co-mortgagors and guarantors of the relevant debt) but not to anyone else.
The equitable duties owed by a mortgagee can be modified by agreement and the Court of Appeal wished to give effect to the contractual agreements made between the parties with the benefit of advice from experienced law firms. In this case, the parties had explicitly agreed that Alphastream's equity interest was fully subordinated in all respects. Such arrangements were undermined by the High Court's decision that Alphastream could be paid damages before the loans in respect of the Aircraft and the Caelus Aircraft had been repaid in full.
PK owed no duty to Alphastream, who had nothing more than a contractual right to receive surplus proceeds should they exist. Even if PK had owed such a duty, there had been no sale of the Caelus Aircraft and so Alphastream could not demonstrate that it had suffered any economic loss.
(2) Sale to Self – the Court of Appeal noted that it is common practice in the aviation industry for a secured creditor to bid at auction to protect the value of its security. In any event, the sale was not a sale by the mortgagee to itself since the Borrowers had (at PK's direction) transferred title to the Aircraft to Wells Fargo as owner trustee prior to the auction. The Court of Appeal found no good reason to expand the self-dealing rule. However, where a connected party sale potentially gives rise to a conflict of interest and duty, the burden of proof is reversed and the mortgagee must show it has discharged its duties.
(3) Best Price – in a connected party sale, the mortgagee must show that it obtained the best price reasonably obtainable. Obtaining an independent valuation is one method for a mortgagee to discharge this duty, but it is not the only method. The valuation relied upon by the claimants did not allow for any discount in a forced sale scenario, ignored the fact that a mortgagee is at liberty to choose the timing and method of realising the value of its security and was predicated on there being a remarketing period. PK had in fact paid more for the Aircraft than anyone else would have been willing to pay in the circumstances. The Court of Appeal confirmed that mortgagees buying mortgaged property are not obliged to pay more than the market price at the time and in this instance, PK had provided sufficient evidence that it had discharged its duties.
Practical implications and looking to the future
Records: Repossession and enforcement of security is often a last resort for lenders and the process requires patience and deep pockets. The clarifications provided by the Court of Appeal helpfully reduce the scope for potential disputes with third parties and unsecured creditors in an already difficult situation. However, Lenders enforcing security would be well advised to maintain clear records of what has been done and why, particularly on any connected party sale so that the reverse burden of proof can be met.
Valuations: Following the first instance decision, language began to emerge in financing documentation addressing when secured parties would be expected to obtain an independent valuation and acknowledging that a sale following enforcement would likely result in a distress value being paid for the asset(s). It is important to note that independent valuations are opinions rather than fact and there can be a wide variance between valuations obtained from appraisers in the market. Although such a valuation can be helpful, it is not always the best evidence and the Court of Appeal judgment made it clear that there is no absolute requirement to obtain an independent valuation in order for a mortgagee to discharge its duties. Going forward there should be no need to suggest otherwise in documentation.
Market Conditions: The Court of Appeal judgment also noted that "the circumstances of a sale influence the price obtainable". By inference, the prevailing market conditions should be considered at the time of any such sale but the Court of Appeal did not discuss in detail the impact of such market conditions on the mortgagee's duty to obtain the best price. At the time of the sale of the Aircraft in 2010, the Aircraft were relatively new and the A320neo had not yet been announced. If the same sale arose today, things might be very different: the market is in transition across four major Airbus and Boeing product types in favour of more efficient aircraft and there is uncertainty in the financial markets. Ultimately, the value of an asset at any given time will be determined by the price a buyer is willing to pay.
The aviation industry is currently in relatively good health: airlines are benefiting from low oil prices, liquidity is readily available and consumer confidence is high. However, many consider that we are at the peak of the cycle and the inevitable downturn is just over the horizon. Mortgagees finding that they must repossess can at least take comfort that they are free to conduct sales on enforcement as they see fit and owe equitable duties only to those with a direct and registrable interest in the aircraft. When it comes to determining the best price obtainable, any clarification the courts can give that the prevailing market conditions at the time of sale should be taken into account would be well received.