Debt Restructuring and Liability Management – Managing Times of Distress for Airlines

In October 2018, we wrote an article on airline restructuring and insolvency^[1], where we considered the key operational risks which have implications for airline survival. That article was written in light of the failure of Primera Air.

Since that article was written, the wave of distress within the aviation industry has continued, and there have been further casualties.  Cobalt Air, a Cypriot carrier, collapsed in October after the Chinese state-owned Aviation Industry Corp, Cobalt’s 49% shareholder, declined to provide additional funding.  The Chinese investment in Cobalt was part of the "One Belt, One Road" project under which China aims to link itself to Europe via Central Asia. Air Zimbabwe, unprofitable for decades, filed for administration late last year. Additionally, several other private airlines, including Small Planet Airlines, Skywork, and, more recently, Germania and Flybmi, have also collapsed. A number of state-owned airlines around the world have also ratcheted up their dependency on their respective governments to stay afloat.  Sri Lankan Airlines was reported to be cash strapped even after capital injections from the Sri Lankan Government, whilst South African Airways continues to rely on support from the South African Government, which recently invested a further five billion rand. 

Failure in the airline business is not new, and has been a more common occurrence since the Carter administration kick-started the deregulation of the airline business in the late 1970s. Renowned investor Warren Buffet reportedly described the airline industry as “being labour intensive, capital-intensive with high fixed costs that has been the death trap of investors”. The recent failures all share a common pattern of business misfortunes. These include an increased cost structure, mainly driven by the rise in fuel and carbon prices, over capacity, increased competition from low-cost carriers, and a lack of new money or equity injection. 

Yet, despite the many horror stories, there continues to be a wave of airline start-ups. In Africa, several governments are setting up new airlines many years after the collapse of their previous legacy airlines.  Senegal and Tanzania set up new airlines in 2017 and 2018. Uganda and Zambia are reportedly in the process of setting up new airlines, as well. Rwandair continues to expand with the support of its government, as does Kenya Airways, which is still in the midst of a turnaround.  These governments view aviation policy as being central to their economic development and modernisation. The airline business is here to stay, which means that getting to grips with how to deal with distress and the cyclical nature of the business is critical to long-term survival and prosperity.

This article supplements our article of October 2018 on turnaround strategies in relation to debt restructuring and liability management.  The high cost structure of the airline business inevitably leads to accumulation of significant debt and liabilities, which are generally of a cross-border nature. Therefore, the ability to manage debt and liabilities on an international scale is critical. The strategies employed may be on a consensual basis with key stakeholders, which is often the preferred option, or within an insolvency legislative framework, as a tool of last resort (if available). Some strategies are "offensive", and thus geared towards revenue generation, whilst others are "defensive" and geared towards revenue protection. However, it is important to bear in mind the following points:

• there is quite a bit of room for creativity in employing these strategies and - just as no two airlines are the same - no two turnaround plans will be the same,
• a critical success factor in any debt restructuring and liability management exercise is the simultaneous application of multiple strategies(i.e. the multi-faceted approach), and
• the strategies must be deployed having taken into account applicable laws, including insolvency laws, notwithstanding the fact that the airline may not yet be formally insolvent (for example, the airline needs to be cognisant of "preferring" certain creditors, or putting assets beyond the reach of creditors).

A high-level overview on some key debt restructuring and liability management strategies follows.

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A. Debt reduction through compromise

In order to fund the high labour and fixed costs, many airlines inevitably have to borrow money. Aircraft (along with their components, such as engines) represent the highest fixed costs whilst fuel and labour tend to represent the highest variable costs.

Aircraft acquisition is usually financed through financing leases or operating leases.  In the case of finance leases the airline borrows part of the financing and/or equity finances any balance required to pay for the cost of the aircraft.  The airline pays interest on the financing and repays the principal upon maturity of the loan and, by doing so, it acquires ownership of the aircraft subject to a mortgage in favour of the lenders.  The aircraft will appear on the balance sheet of the airline as an asset and the corresponding liability will appear as debt.  For operating leases the airline leases the aircraft for a prescribed period of time in return for payment of a security deposit, rent, and maintenance reserves.  The airline does not acquire ownership of the aircraft, only a “right of quiet enjoyment”. Under current international accounting rules the aircraft does not appear as an asset on the balance sheet of the airline. 

Fuel is generally expensive, and its pricing is erratic with significant upward and downward swings. Therefore, there are various fuel procurement structures under short-term and long-term arrangements.  Additionally, labour costs can be high and are often also wedged within the politics of labour unions. For example, the costs of crew (in particular, cockpit) may not be in line with the local labour market since these are often benchmarked internationally.

A distressed airline facing a high debt burden may have its work cut out for it.  As already highlighted, this can be further complicated by the cross-border or international nature of creditors.   However, distressed airlines should not shy away from engaging with creditors to achieve a compromise.  In our experience, if properly advised and with the right approach, a distressed airline can often secure a compromise with at least the majority of its creditors.

Creditors faced with a distressed borrower or counterparty will often have a range of options available to them, and will weigh the likely outcomes from the options and pursue what they believe best optimises their recovery.  Creditors, particularly those which are unsecured, will be wary that their actual recovery in a liquidation scenario will likely be significantly diminished. Creditors also have other considerations, such as reputational risk and long-term relationships, which the airline or its advisors have to tap into when formulating compromise proposals.  This is an art, and engaging the right advisors is key.  If the creditors are poorly managed, this can lead to the quick or premature demise of the airline. 

We set out below some of the possible negotiating points and strategies airlines can adopt toward their various creditors.

Creditor classes: For the purposes of facilitating negotiations with creditors, the airline may group them into appropriate "classes" in line with the similarity of their rights or claims, and in turn prepare compromise proposals for each class.  This promotes some form of fairness in treatment.  As a broad example, the following classes may exist for an airline business:

1. priority creditors (e.g. employees, tax authorities, airport traffic and ground handing);
2. secured creditors (e.g. aircraft financiers, lessors);
3. trade creditors (who are vital for the operations of the business e.g. catering, fuel); and
4. unsecured creditors.

Standstill: In a consensual resolution, the creditors can be persuaded to refrain from taking any adverse action for a period of time in order to give the airline some breathing space to find a solution.  In practice this can be complicated, especially when dealing with creditors who have sufficient leverage to disrupt the operations of the airlines such as the aircraft lessors or fuel suppliers.  It all comes down to negotiation skills including finding win-win situations that are workable for the relevant stakeholders.

Renegotiation of financing terms:  This includes renegotiation of the terms of the financing agreements such as reduced interest rates, reduced lease or maintenance reserve rates, extension of maturity dates, reset of covenants, waiver or suspension of events of default/other breaches, clean-up periods to allow defaults to be cured, to name a few.  The objective of the airline is to realign its obligations with its cash flow.  The lender/lessor may agree to the renegotiated terms in return for a strategic benefit.  This may be to avoid the inconvenience, obstacles and value destruction associated with enforcement, or for a consent fee, or to support the continuing survival of the airline for future business.  Therefore, the key is to identify the strategic benefit or the lender/lessor’s vulnerabilities and best utilise them. 

Debt-to-equity swap: The debt-for-equity swap entails certain of the financial creditors discharging indebtedness owed to them in exchange for one or more classes of the airline's shares.  In order for the participating creditors to agree to a debt-to-equity swap, they need to buy into the future business plan, the strategic plan and the prospects of the airline.  Kenya Airways is reported to have successfully pursued this strategy in 2017.

Debt-for-debt swap: This involves exchanging some of the existing indebtedness for new debt instruments at revised terms and more sustainable repayment profiles.

Debt write-down: In certain cases, creditors may be incentivised to consider taking “haircuts” on their outstanding debt or claims. 

Deferral of payments: The airline may explore deferral of debt payments or some other form of amortisation of existing liabilities. Creditors may agree to a deferred payment structure provided it gets the bad debt “working” again.

An interesting current case study is Jet Airways, which reportedly has a funding gap of around $1.2 billion. At the time of this article, the company is planning to ease cash-flow concerns through a number of measures including a mix of new equity, restructuring of existing indebtedness and sale/refinancing/sale-and-lease-back of aircraft.

B. Disposal of non-core assets

Non-core assets are assets which are not fundamental for the short-term survival of the airline’s business. Such assets may be disposed of and the proceeds used to pay off some of the airline's debts.  The airline may sell excess aircraft or spin off non-essential divisions or even intangibles such as unused or particularly valuable landing slots. For example, in 2016, Kenya Airways was reported to have sold its premium 5:30am Heathrow landing slot for USD75 million.

C. Cash management strategy

Cash is king in times of distress. This is partly because credit dries up. For example, previously collaborative trade suppliers are more likely to ask for advance payment or money on account in the wake of distress. Therefore, a stringent cash flow management strategy is fundamental for the survival of a distressed airline.   It may be advisable to appoint a cash manager whose main task is to prioritise preservation of cash, pay priority creditors (i.e. those who are vital for continuity of operations) and defer the payment of others.  Ultimately, this task is an art that is best executed by an experienced professional. 

D. Cost reduction

It is common practice for distressed airlines to make certain cutbacks to free up liquidity - and unlike certain other revenue generation strategies, these measures do not incur upfront costs. For example, the currently troubled Jet Airways has implemented a number of such measures, including cuts to passenger meals, revised ticket change/cancellation fees, removal of lounge access in some cases etc. The key with these types of changes is that they do not compromise the passenger experience to the point where it affects the airline's sales/reputation.

E. Revenue generation

Increasing revenue sources to counter negative cash flow is a common strategy for many airlines.  This is often manifested in various forms such as the introduction of new routes, a marketing and advertising drive, promotions and packages.  Rwandair has recently employed this strategy by opening new routes to London and the US.  Kenya Airways has opened routes to Rome and Geneva.  Icelandair also reorganised its routes in 2018, following a comparatively poor financial year. In other cases, alternative revenue sources such as investments in hotels, tourism packages or MROs may be used.

However, caution is required in relation to this strategy as it requires new capital investment and an airline may find itself deeper in the red if the revenue maximisation strategy does not work or the cost structure remains high.  Airlines such as Saudia and Etihad continue to register losses despite the drive towards revenue generation through market share. 

F. Public relations and communications strategy

Distressed airlines invite adverse press coverage and poorly or even misreported uncertainties can lead to the eventual demise of an airline.  It is important to have in place an effective communications strategy especially with creditors. An effective communications strategy needs to capture both the local dimension and the international, given the cross border nature of the business.

G. Consolidation 

This is a far reaching topic which merits a separate article in its own right.  In simple terms, airline consolidation refers to the merging of airlines in order to benefit from, among others, the efficiencies of scale, reduced competition, increased purchasing power and maximised revenue. For decades, airlines were straitjacketed by regulations and protectionism that prevented mergers and the emergence of low-cost carriers.  The US led the way in liberalisation, followed by the EU.  However,  a succession of economic calamities starting in the US and then in Europe have had an even bigger effect, saddling carriers with unsustainable cost bases and leaving consolidation as an overwhelming imperative.  

The US started to lean towards consolidation following a spate of bankruptcies. The US now has four major airlines: United Airlines, Delta Airlines, American Airlines, and Southwest Airlines, which together control around 70% of the air travel in a country that spans a continent.  Profitability has been re-established, even prompting Warren Buffet (who, as we mentioned above, was a critic of the airline business for decades) to invest.  At the core of airline consolidation is that the industry is better served with fewer airlines, that bigger is better, and that there is a strong correlation between size and efficiency.

Consolidation has been less successful in Europe and, on the face of it, European airlines are making a lot less money than their US counterparts.  Critics of consolidation allege that the strategy is anti-competitive, limits consumer choice, and is thus a burden to the consumer as it can trigger increases in the cost of air travel.

Some economists have argued that the airline business faces an “empty core” problem whereby the presence of a given number of actors in a defined market may lead to loss-making for all actors. This creates additional problems for the affordability and profitability of the airline business in certain emerging markets such as Africa, the Middle East and Asia.  For example, a number of East African airlines (other than Ethiopian Airways) are yet to achieve profitability.  In 2018, Kenya Airways reported continuing poor performance which was partly exacerbated by the introduction of Air Tanzania.  Similarly, stiff competition continues between Rwandair and Ethiopian Airways.

There are also other factors at work which create a very high cost structure including, among others, low flying population, low income levels, operational inefficiency, poor airport infrastructure, currency fluctuations and high fuel prices.  This is not helped by excessive competition.

Therefore, in times of distress, airlines may consider the viability of consolidating their operations with an appropriate competitor, who either may be faced with similar circumstances, or stand to benefit from the deal. 

If the above cannot be achieved within a consensual process, the airline may consider the use of a formal insolvency proceeding.

H. Use of an insolvency process

Whilst a consensual resolution of debt and liabilities is normally the preferred route, in some cases it may be impossible to achieve a resolution without the assistance of an insolvency legislative framework. Historically, there has been somewhat of a stigma attached to filing for insolvency or bankruptcy (even temporarily as a means of reorganization/business rescue), particularly in certain countries. Therefore, from a reputational risk perspective, some companies have preferred to explore other options, as opposed to using bankruptcy tools as a shield under which to reorganize themselves.  The stigma attached to business rescue filings is often misinformed and inconsistent with the reality that business rescue is a normal stage within the life cycle of most corporations nowadays. 

Another important factor is that the legislative framework in many countries has not yet been sufficiently developed to facilitate business rescue or restructuring - certainly not on the scales of, for example, the US. Instead, these jurisdictions generally facilitate some form of liquidation or wind-down.  That said, there is a concerted movement in many countries to update their insolvency laws to introduce a business rescue or turnaround regime. Airlines in distress are encouraged to consider all options, and explore formal restructuring relief under local laws, if such regime exists, or alternatively, ascertain whether relief may be available internationally. Globalisation is increasingly making it possible for companies to be flexible regarding in which jurisdiction they choose to file for insolvency (subject of course to sufficient connection to said jurisdiction).

An appropriate insolvency framework has various tools such as, among others (a) triggering a moratorium i.e. the ability to stay or prevent creditor action against the insolvent or bankrupt entity; (b) facilitating improvement in the cost structure by negotiating reductions in debt, or expunging certain onerous contracts; (c) facilitating recapitalisation or new money, potentially from new sources, as priority funding (or super-senior) over existing debt or liabilities; and (d) facilitating cram-down of hold-out creditors in relation to any restructuring proposals.  

As an example, the US arguably has one of the more developed and comprehensive insolvency frameworks for business rescue or turnaround under Chapter 11 of the U.S. Bankruptcy Code. Given the cross-border nature of the airline business, where local law cannot facilitate a turnaround, a filing of proceedings under Chapter 11 of the U.S. Bankruptcy Code may be worth exploring.  A filing under Chapter 11 can offer the full benefits of the U.S. Bankruptcy Code and in particular the worldwide “automatic stay” against collection and seizure of assets “wherever located”. In recent years foreign airlines such as Colombian airline, Avianca, have used this approach. In order to access the US Bankruptcy Courts the foreign airline must prove a connection to the US, but the threshold is low; for example, a bank account in the US may suffice. 

Of course, the use of the US Bankruptcy law is not without legal risk or drawbacks.  It can be expensive and there are other requirements which may be deemed onerous and disadvantageous, such as stringent disclosure obligations.  Issues surrounding politics and the enforceability of decisions handed down by a US Bankruptcy Court in the home country must also be carefully considered. 

Alternatively, English regimes, such as schemes of arrangement (although strictly more of a cram-down process than an insolvency regime), have proved to be of interest to overseas companies.

International insolvency practice, including the UNCITRAL Model Law, has also increased options for insolvency routes which are worth exploring. For example, in order to optimise restructuring through the use of insolvency law, it is possible to conduct parallel local and international insolvency proceeding. Recently the Italian airline Alitalia filed for Chapter 15 bankruptcy protection in the US in order to protect its US assets, in addition to extraordinary administration proceedings in Italy.

Finally, there are instances where the existing laws of an airline’s home country are simply inadequate to facilitate a restructuring.  In some cases it may be possible for the government to pass a special resolution regime targeting the restructuring of a company which is of national significance.  We have recently witnessed this approach in various countries.  Croatia did this to facilitate the restructuring of a main supermarket chain, Agrokor.  Cape Verde has recently implemented a special resolution regime to facilitate the resolution of debts of its national flag carrier.

The use of insolvency proceedings to expunge debt and liabilities is a strategic option worth exploring as a tool of last resort.

In conclusion, for airline companies in distress, maintaining an open mind, flexibility, and carefully working through all the available options is critical to whether a company will be able to achieve turnaround and continue its operations, or if it joins the ever-growing list of airline casualties.

^[1] Law 360 - "Critical Factors for Airline Survival and Restructuring".