On Tuesday, 2 October 2018, Primera Air joined the list of airlines which have filed for insolvency in the last 12 months. The airline, a low cost carrier which has its origins in Iceland but subsequently moved its operations to Denmark, was owned by the Icelandic Primera Travel Group. Primera Air flew seven Boeing aircraft from bases in Iceland, Denmark, Sweden and Finland. It offered transatlantic flights from Birmingham and Stansted airports in the UK with flights to Washington, Newark, Boston and Toronto.
Ironically, Primera announced in January of this year that 2017 had been a record year, with a 13.7% increase in revenue compared to the preceding year. The number of passengers carried in 2017 exceeded 1 million, and it is calculated that there had been a consistent load factor of 85% on flights operated by Primera. Things appeared to be going well for the company!
The insolvency of Primera Air follows closely on the heels of Monarch, formerly the UK’s fifth largest airline, which was restructured twice with capital injections from Greybull Capital. Following the 2014 takeover Monarch restructured its position in the market, implementing a low-cost business model that entailed a reduction in fleet and staff, in a bid to reduce its operating costs. However, Monarch’s fate was sealed by the impact of terrorism, Brexit, and market competition. In November 2015, following terror attacks in Egypt, the Egyptian Government banned flights to the region. This was particularly problematic for Monarch, as it had focused largely on flights to Sharm-el-Sheikh. Later, in 2016, the decline of the pound following the Brexit referendum took another toll, as it was reported that the majority of Monarch's revenue was taken in pounds while its aircraft leases, fuel, ground handling costs, and other operating expenses were being paid in euros and dollars.
Airline restructurings and insolvencies are complex, multi-faceted, cross-border operations with many variables. The aviation industry is notorious for business failure given its sensitivity to a wide range of factors, from political instabilities, fuel prices, and foreign exchange to natural disasters, terrorism, and disease. It is also highly sensitive to mismanagement and poor decisions. It is a cyclical and seasonal industry, which is further squeezed by a reverse working capital cycle. Coupled with aggressive competition from low cost carriers and greater fare transparency as a result of increasingly accessible internet tools, airlines can face liquidity pressures from numerous angles.
So what went wrong for Primera, and why the sudden fall from grace? Those familiar with the aviation industry will recognise the pattern, after all there are enough case studies out there. Erratic business model; over-ambitious route plan; poor fleet plan; significant technical exposure; excessive debts followed by reduced access to new money. Eventually all these culminated into unsustainable operating costs, which the company had not accounted for in its business plan. Insolvency almost always follows when other macro-economic factors, such as increased fuel prices come into the mix.
Distressed or insolvent airlines will normally require two restructuring initiatives:
- debt restructuring and liability management, which normally involves a reorganisation of the capital structure, resolution of liabilities, and renegotiation or termination of onerous contracts. This may be done on a consensual basis or within formal insolvency proceedings such as an administration filing in the UK or a filing under Chapter 11 of the US Bankruptcy Code; and
- an operational restructuring, targeted at, among others, enhancing the airlines business model and improving operations.
This article considers the issues and strategies pertaining to the operational restructuring of airlines and looks at case studies, such as Primera Air and other airlines. A separate article will follow on the issues and strategies pertaining to the debt restructuring and liability management.
Technical exposure: Primera Air’s management cited severe corrosion to one of their Aircraft as one of the main contributors to the failure of the airline. The full facts pertaining to the corrosion have not been disclosed. However, this is a well-known technical (and major) risk that airlines and their advisors need to pay attention to alongside other technical risks around the condition and maintenance of the aircraft. As evidenced by Primera Air, the cost implications can be catastrophic.
A significant amount of the negotiation in relation to the purchase or lease of aircraft relates to its technical conditions, including:
- the condition of the aircraft at delivery;
- the scope and nature of inspections to be undertaken by the airline company prior to accepting delivery;
- the on-going maintenance requirements, including apportionment of costs (and the extent to which, for example, maintenance reserves may be utilised for certain repairs); and
- the return conditions of the aircraft (if acquired on lease).
For used/aged aircraft, in particular, counterparties can often be pulling in opposite directions on the above points. However, aircraft contracts are a mature industry and there are so called “market standards” in relation to risk allocation. In our experience, whilst “misfortunes” occur in relation to technical exposure, many airlines can become unduly exposed due to poorly negotiated arrangements, mismanagement, sheer technical incompetence, or lack of foresight, which often comes to light later on during the term of the aircraft lease or during restructuring or insolvency.
The delivery conditions for the aircraft should expressly set out the required technical condition of the aircraft, including matters such as corrosion, at delivery, and the lessee should conduct appropriate borescope inspections to verify delivery conditions as far as possible. Whilst this sounds obvious, it is not always the case in practice. For example, it is not unusual for lessors to require more stringent conditions on return of the aircraft than when it is was delivered. Common sense would have it that the delivery conditions and the return conditions of the aircraft must at least be aligned, but the relative negotiating power of the parties or the commercial considerations at the time of entering the agreements may prevail. It also goes without saying that it is advisable to include the airline’s technical team in the negotiations in relation to the aircraft as early as possible.
The airline’s technical team must thoroughly inspect the aircraft in accordance with the agreed inspection protocol in order to ensure that it complies with the delivery conditions. This can be a protracted process as sellers or lessors are minded to limit the scope of the inspection. The market convention is that aircraft are delivered in “as-is where-is” condition. It is the airline’s obligation to thoroughly inspect the aircraft and, once this is completed and aircraft accepted, the technical risk passes to the airline.
The inspection covers aircraft documentation and actual physical inspection. There is a whole of range inspections of varying complexity that can be performed, including general visual inspection; detailed inspection; special detailed inspection; borescope; test flights; etc. Other checks may be required to address corrosion, such as investigations into the previous operating environment of the aircraft, previous maintenance protocol, and review of whether the manufacturer’s maintenance planning document (MPD) includes corrosion tasks. In summary, the airline’s prudence in this process, or lack thereof, may have implications in due course.
After the airline has acquired the aircraft, it is normally expected to conduct maintenance in accordance with the agreed maintenance regime, often referred to as the Agreed Maintenance Program or AMP. For example, the AMP will likely include corrosion prevention and/or protection program (otherwise referred to as CPCP Tasks). Aircraft maintenance is a very expensive business. In modern airline management, airlines are expected to set aside a pot of money (the maintenance reserve) on a monthly basis to cover technical risks. Here lies the “shortfall” that we find in many failing airlines. Some airlines which own the aircraft may find the practice of setting aside maintenance reserves too cumbersome for their cash flow requirements and are either lax about following through, or simply do not set aside enough (i.e. the maintenance reserve pot becomes under reserved). When catastrophe strikes, as it did in the case of Primera Air, the airline company may scramble to find cash, in some cases with dire consequences.
For airlines which lease their aircraft, the lessor will often mandatorily require them to pay (in addition to rent) a maintenance reserve calculated on the basis of an agreed formula. We have come across a number of weaknesses in the execution of the maintenance reserve protocol that can sometimes put the airlines in a difficult financial position further down the road, notwithstanding that it has contributed to the reserves.
Firstly, lessors sometimes book the maintenance reserves as revenue and in fact characterise them as “rent” for the purposes of the lease agreement in order to, among others, defeat the creation of an equitable trust in favour of the airline. This means that the airline is unable to automatically access the reserves when faced with a maintenance event and has to request a contribution pursuant to the terms of the lease agreement. Unfortunately, sometimes lessors are hesitant contributors to maintenance events (comparable to a landlord in respect of service charges for a block of flats).
Secondly, many airlines are faced with poorly negotiated terms or conditions for accessing the maintenance reserves. For example, maintenance reserves are available only towards certain agreed maintenance events (the so called “qualifying works”) and particular maintenance events may be carved out as being ineligible for contributions out of the maintenance reserves. In fact, in a number of aircraft leasing agreements we have seen, we found that “corrosion” was carved out non-scheduled maintenance, although it remains unknown whether this is the fate that befell Primera Air. In other cases the maintenance reserve is paid into specific sub-pots, such as aircraft frame, engines, landing gear, and propeller parts, rather than into a single pool. The reserves in a particular sub-pot may only be used towards a maintenance event relating to that sub-pot. The issue with this structure is that sometimes there is simply not enough reserve in a particular sub-pot to cover the cost of repair of a particular maintenance event, and the airline is then faced with financing the shortfall out of its own pocket (notwithstanding that the lessor may be sitting on a significant amount of money contributed by the airline across other sub-pots). Moreover, many lessor contributions are made by way of reimbursements, meaning that the airline has to finance the repair in the meantime. All the above are ultimately negotiating points in the underlying documentation.
Routes and Fleet Plan: The airline’s fleet plan and the routes to be flown are two interconnected aspects which ultimately feed into the business model of the airline. It is astonishing how many managers of failed airlines get this wrong. For example, Primera Air cited the delayed delivery of aircraft from Airbus as one of the causes of its insolvency. Operationally, Primera Air committed to several new routes and pre-sold tickets whilst it did not actually have the aircrafts to service those routes. Once faced with delays, it then scrambled around for wet-leases. These are aircraft leasing arrangements which come as a package with crew, maintenance, and insurance. Such arrangements can be immensely expensive, even more so if entered into at a late stage.
Airlines have obligations under Regulation (EC) No 261/2004 to compensate and provide assistance to passengers in the event of being denied boarding, or of cancellation or long delays to their flights. Primera Air would have been faced with this issue and would have had to put in place alternative arrangements which purportedly cost it up to €20 million, eventually contributing to its demise.
The above points to over-expansion without an appropriate fleet plan in place and certainly without an alternative or back-up plan. Primera Air started, or announced, new routes as recently as September 2018. It had an ambitious programme for the requisition of new aircraft, the terms of which are still unknown to the public. Moreover, it does not appear to have a strategy in place for accessing aircraft in the wet-lease market in order to minimise vulnerability to over inflated prices.
The airline’s management needs to bear in mind that the fleet comprises the airline's key assets, without which it simply cannot conduct its business. Further, lack of aircraft can affect other parts of the business model. If an airline does not use its take-off and landing slots, there is a danger that it forfeits them under EU regulations (the “use it or lose it” rule). Accordingly, a review of passenger load factor needs to take place at the earliest opportunity to determine and maximise utilisation of each aircraft. All aircraft lessors or suppliers need to be engaged and encouraged to cooperate, and alternatives should be considered. Good restructuring advisors take the view that nothing is cast in stone and everything is subject to renegotiation with the ultimate objective of facilitating the survival of the airline. The key is to identify the “win-win” positions in the circumstances.
The operational restructuring of a distressed airline will also normally involve a comprehensive review of the airline's routes with a view to identifying the profitable and non-profitable routes. The poorly performing routes should be abandoned or discarded, albeit this exercise is not straight forward. For example, some poorly performing routes may actually be feeder routes into the more profitable routes, or may have other strategic benefits. The route review will need to tie in with the airline's overall restructuring strategy and link in with other restructuring strategies including headcount, cost reduction, asset disposal (for example, it does not make sense to dispose of aircrafts with long range capability if the airline is intending to boost its long haul operations), and other elements such as code-sharing or formation of an alliance/partnership.
Management Enhancement and Operational Efficiency: Just like the medieval statement “All Roads Lead to Rome" arguably the equivalent for failed businesses is “All Roads Lead to Management”. This is at least the starting point for any restructuring.
It is well-documented that existing management are often unlikely to have the resources, time, or know-how to execute a turnaround strategy whilst at the same time also continuing the day-to-day running of the business. Moreover, they may be unable to consider their past actions with impartiality.
There are two major management strategies that are fundamental to the stabilisation and eventual survival of a struggling airline: cash flow management strategy and cost-cutting. Cash is king for any distressed business, but this is even more true for an airline due to the high cash burn in running operations. Moreover, the extended value chain for the airline business not only creates many opportunities for cash leakage, but also creates room to be held hostage by lessors and suppliers. Airlines are at the bottom of the value chain. It is therefore imperative that robust cash management and conservation plans are in place. The sister to cash management is cost cutting. This normally starts with a reduction of the number of employees. It also involves identifying any other cost centers where savings are possible, usually a ruthless process if the full benefits are to be reaped.
A Chief Restructuring Officer (or CRO) will normally be appointed with to the purview of overseeing the entire turnaround strategy. These are skilled individuals who specialise in distressed situations and will tend to be appointed from outside the business, and thus have no emotional attachment to the past. The CRO frees up the management team to focus on day-to-day running of the company and to not be distracted by the restructuring. However, they may also be empowered to assess management capabilities and competencies, which may eventually pave the way for management change.
The cost cutting in relation to employees is usually intended to make the company leaner and more streamlined. Obviously such measures must be taken in accordance with local labour laws, and in consultation with relevant trade unions and local counsel, thereby minimising litigation risk. This area must be handled in a sensitive manner in order to avoid alienating the remaining employees. It can be challenging to keep the best employees from departing and to maintain high levels of morale among the remaining employees against a backdrop of restructuring. Thought should be given to employee incentives schemes in order to motivate employees and generally use them as the valuable resources they are (these individuals perhaps know the company best).
Corporate reorganisation: A part or full reorganisation of the airline’s corporate structure may be required to enhance and optimise operational efficiency, facilitate alternative revenue sources (such as hotels, travel packages, MRO etc), and facilitate new money investment. We have seen this most recently with Malaysia Airlines. On 1 September 2015, Malaysia Airlines Bhd became Malaysia's new national carrier. The transition meant that the previous legacy-laden airline company was left behind, and a new (and leaner) company emerged. Splitting an ailing company into two is not unusual. It helps to isolate the loss-making and indebted parts from the debt-free, lean and profitable operations, giving the company a reasonable chance of survival. Thought should be given to operational aspects and long-term sustainability when implementing this type of structure and, in particular, the licenses. For example, which entity will hold the Air Operator Certificate (“AOC”). It is important to note that AOCs are not transferrable from one legal entity to another. Therefore, where a restructuring is planned which involves a similar structure to that used by Malaysia Airlines, the creation of a new entity will bring with it the obligation to apply for a new AOC. There are other licenses to take into account as well such as IOSA certifications and, in the case of legacy airlines, whether there are implications under the air services agreements.
New Money: Almost all restructurings will require the injection of new capital, without which the restructuring is unlikely to succeed. Ultimately, it was Primera Air’s inability to attract new funding that consummated its collapse. Success in acquiring new sources of funding will depend on how attractive the restructuring proposition is, including the business plan. Investors in distressed companies tend to look forward, not backwards.
The airline may also seek to use alternative financing solutions, including leveraging on its assets. For example, Monarch attempted to securitise its landing slots to raise money, albeit this initiative was not successful. Kenya Airways sold its Heathrow slot, whilst Virgin successfully securitised some of its slots.
State-owned airlines can often turn to their respective governments for bailouts. Iberia, Aer Lingus and Air France all used state aid to affect their turnaround plans. Full or partial privatization is often a part of the scenario when the government pumps in additional funds to help turn around its national airline, it is then quickly able to recoup its investment. An example of this being Air France, which used government bailout to affect its turnaround before achieving a part privatization followed by a listing on the Paris stock exchange.
In conclusion, as highlighted in this article, it is critical for airline survival to effectively manage operational risk. Some of the most critical operational factors are cost structure, operational efficiency, resolution of technical exposure, and the management's competence, all of which need to be geared towards the execution of an effective business model.
 The airline value chain includes (not necessarily in priority) lessors or financiers of aircraft, fuel suppliers, airports (landing charges and gate rights), ground handling, travel agents, overflight services, catering, and others including passengers.
Henry Kikoyo is a Partner at Brown Rudnick LLP and regularly advises in relation to airlines in distress and insolvency including debt and operational restructuring. He has particular experience acting for airlines operating in emerging markets which are faced with inadequate institutional and legal framework to support effective turnaround initiatives. He also acts for lessors and creditors in relation to recovery out of insolvent airlines including enforcement and repossession of aircraft. He is part of a Transatlantic team of lawyers practicing in aviation, insolvency and other sectors, who are well prepared to advise on complex and cross-border legal problems arising out of specialist sector insolvencies.
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