April 14, 2020
Although the EU’s introduction of a Temporary Framework has enabled governments to offer extensive State-backed loans, the airline industry needs more than just credit—it will need equity. However, State aid to the aviation industry is strictly regulated by the European Commission (the “Commission”), and so only airlines that can show their business will be viable post-pandemic are likely to receive further aid. It is unlikely that the COVID-19 outbreak will cause changes to the stringent regulation on airline mergers. However, the suspension of the “use-it-or-lose-it” slot rule may have implications for any airline insolvencies, and will likely continue the trend of slot trades at reduced valuations. Finally, the extent and structure of aircraft leases in Ireland, under which banks have excessive exposure by lending 85% of the cost of each aircraft, may create an extra risk of a banking crisis in Ireland.
In Europe, any form of government support requires the Commission’s approval under the State aid rules. There are four key points to be borne in mind:
first, that the Commission can act quickly. The State aid system need not be a barrier to the speed with which a Government can help;
second, the Commission has a long history of attempting to police State aid to the airline industry. They remain deeply skeptical—especially for flag carriers with longstanding viability issues. Government bailouts of otherwise viable airlines are much more likely to obtain timely approval with limited conditionality;
third, the measures approved so far are designed to meet liquidity needs. Airlines are likely to need fresh equity, not just credit. This will require airlines to break new ground in the crisis response; and
fourth, the financial crisis taught us that the State aid system is more generous to those that request aid early in a crisis than those who wait. Existing shareholders will likely be diluted significantly in a rights issue or bought out at low current prices in a full nationalization. Creditors—including bond investors—are likely to be protected.
The Commission has swiftly responded to the COVID-19 crisis by both relaxing the substantive rules and approving EU Member States’ aid schemes quickly. On March 19 2020, the Commission published a Temporary Framework that will allow EU Member States to implement aid schemes such as direct grants, selective tax advantages, subsidized public loans and State guarantees for loans taken out by companies from banks. The Commission has already approved schemes in line with this framework in France, Germany, U.K., Italy, Latvia, Luxembourg and Portugal.
However, many airlines will likely need more than just State-backed loans. Passenger demand has almost completely collapsed against high fixed costs. Many in the industry will rapidly burn through available cash. Balance sheets may not be able to sustain further borrowing—even if guaranteed. Equity injections from existing or new investors is likely to be needed even for strong companies. In many cases that investor will need to be the State. The Commission started a consultation on permitting aid in exactly this way just before the Easter break.
The Commission remains deeply skeptical of State aid to airlines—especially for flag carriers with longstanding viability issues. However, whilst Moody’s has recently downgraded easyJet’s rating and put British Airways owner, IAG, on the downgrade watchlist, these airlines and others that were solvent before COVID-19 are much more likely to be able to obtain State aid and with less conditionality. Conditions often include having to downsize operations, sell slots at congested airports to new entrants and sell non-core subsidiaries (catering, engineering, travel agency, airline brands).
State aid measures can be approved under various grounds. The preferable ground for airlines would be Article 107(2)(b) TFEU: to “make good the damage caused by natural disasters or exceptional occurrences.” This provision was widely used in the wake of 9/11, and is appealing since the Commission cannot impose conditions for aid under this category. However, the Commission will not consider nationalization or State equity participation under this heading. This is much more likely to follow the playbook seen in the rescue and restructuring of banks during the financial crisis. In return for public money, airlines will likely need to show how the business will become viable after the pandemic, for example by selling planes, dropping routes, laying off staff or divesting airport slots.
In addition to direct financial support, other rules are being relaxed for the airline industry. For example, on March 19, the Norwegian government temporarily suspended competition law rules in the transport sector, including in respect of specific airlines, for three months. This allows airlines SAS and Norwegian Air to cooperate to ensure the maintenance of minimum passenger services and socially critical functions by coordinating flight schedules. As well as having to notify Norway’s competition authority of the activity, there are limitations on when coordination is permitted and the Norwegian government retains the ability to introduce exceptions if the measures have an impact on socially critical functions. The exemption should nonetheless help maintain transportation services for passengers and goods for the duration of the COVID-19 outbreak.
The Commission also issued a more general Temporary Framework on April 8, to assess potential antitrust issues arising out of business cooperation in light of COVID-19. The framework, which focuses on ensuring an adequate provision of essential and scarce products and services (including those in the medical sector), suggests that ordinarily anti-competitive cooperation between competitors may be permitted where such cooperation is: (1) designed and objectively necessary to efficiently increase output to address or avoid a shortage of supply; (2) temporary; and (3) does not exceed what is strictly necessary to achieve the objective. The Commission is also able to provide ad hoc comfort letters on the legality of certain companies’ cooperation in this regard, whilst continuing to monitor undertakings taking advantage of the current situation to actively breach EU competition law.
More specifically related to cargo airlines, the European Commission released guidance on facilitating air cargo operations during the COVID-19 outbreak on March 26, recognizing the potential need for international cooperation in the aviation industry to ensure the supply and fair distribution of products. The guidance, which relates to the maintenance and facilitation of air cargo operations (including the transport of essential goods, particularly where delivery is time-sensitive), encourages Member States to implement temporary operational and organizational measures until air traffic and travel restrictions are lifted. Such recommended measures include granting necessary authorizations and permits for transport from outside the EU, temporarily removing night curfews or slot restrictions for essential air cargo operations and exempting asymptomatic transport personnel from travel restrictions. The Commission emphasized that these measures are targeted towards preventing shortages of essential goods and services, and it will continue to prohibit companies cartelizing or abusing their dominant position.
No industry’s ownership is more strictly regulated than that of the airline industry. Without exceptions, a U.S. airline cannot be controlled by a non-U.S. person nor can an EU airline be controlled by a non-EU person. The COVID-19 pandemic raises familiar questions around some of the barriers to a worldwide consolidation of airlines.
Airline insolvencies are nothing new. In 2019 alone, an economically prosperous year, 23 European airlines filed for insolvency. In March 2020, British Flybe did the same. These insolvencies did not create any particular political or economic concerns and, at least in Europe, the legal framework for the ownership of airlines is not broadly criticized (other than in the U.S.). In Europe, the discussion rather focuses on the protection of consumers against financial losses resulting from insolvencies for pre-paid tickets.
Thinking forward, two questions are to what extent M&A may in the future help airlines to increase their resilience and which transactional moves can be expected in the airline industry as a result of the COVID-19 Pandemic.
Within the EU, Member State airline mergers do not face merger restrictions in principle for as long as the EU ownership rules are observed. However, major airlines face antitrust scrutiny if they are interested in acquiring competing EU airlines. The EU Commission reviews airline mergers on a route-by-route basis. That means that if too many routes overlap, the expected clearance conditions may make a merger unattractive or too risky. In contrast, a merger of equals between European and U.S. airlines or a divestiture-like transaction to a third party not being a U.S. or an EU person, respectively, is per se not possible, as already stated above. However, interestingly, the position is different with respect to airports, aircraft producers or service providers to airlines or airports, which can all be controlled by non-U.S. or non-EU persons. The ownership of airlines could simply fall under the foreign direct investment rules (“FDI”) of the Member States like other critical industries. Therefore, when it comes to M&A activity in the airline industry, consolidation is restricted by antitrust concerns and by ownership restrictions.
It seems unlikely that competition authorities will take a more relaxed approach to airline merger reviews in light of the current crisis. Canada’s Competition Bureau (the "Bureau"), for example, has announced that Air Canada’s proposed acquisition of Transat is likely to weaken competition in the sale of air travel or vacation packages to Canadian consumers. Although the Bureau stated that the impact of COVID-19 may be relevant to the merger review process, it has still taken a traditional approach to its analysis by focusing on the possibility of consumer harm in the form of increased prices, decreased consumer choice, decreases in service and a reduction in travel on a variety of routes.
Through the trading of landing slots, air traffic can be consolidated without the acquisition of the underlying business or any assets or personnel. The trading of slots is generally permissible in the U.S. and in the EU but some countries in the EU, for example Germany, take a more restricted view. So far, the German position was that a slot could only be transferred together with an aircraft. It appears that this position is unlikely to change in the near future. Under the so-called 80–20 IATA/EU rules an airline is required to use at least 80% of the landing slots within a given period in order to keep such slots within the corresponding period of the next year. The EU Commission agreed on March 30 2020 to suspend such “use-it-or-lose-it” rules until October 24 2020, to mitigate the economic impact of the COVID-19 crisis. A particular benefit is that airlines will no longer have to continue to operate flights, even if largely empty, to guarantee their current slots at EU airports. However, airlines will be required to temporarily return slots they do not intend to use during the 2020 summer season. The Commission retains the right to extend these measures if the crisis continues beyond this date.
After the end of such suspension, the rule may create obstacles in the case of an airline insolvency if the flight operation cannot be continued during the insolvency proceedings, as the value of the slots cannot be monetized by the insolvency estate. Airlines interested in acquiring relevant slots must participate in the allocation process organized by the relevant national slot authority that allocates all slots that are being revoked (including resulting from the 80–20 rule or lack of financial strength). In any event, it is not difficult to predict for the future more landing slot trades at reduced valuations. The Commission will in any case monitor the situation and report back by September 15 2020.
The leasing of a complete aircraft together with crews and slot rights is an additional tool in the airline industry to consolidate the market. When two airlines compete for a specific route, the competition terminates if one of the two airlines leases through a wet lease arrangement with the other an aircraft, a crew and the right to use the slot of such route. This concept has been broadly used by Lufthansa to take over routes from Air Berlin, even before Air Berlin became insolvent. Interestingly, the EU Commission reviewed the Air Berlin wet leases and did not object as it did not see a relevant merger transaction in light of the continued ownership of the aircrafts and the slots by Air Berlin. Wet leases are a widely used tool in the airline industry and we expect that this will continue.
As a result of the COVID-19 situation, airlines that also operate service units, like catering or technical maintenance services, are expected to (re)consider their business set-up. Activities of airlines to divest non-core businesses will possibly increase. As with most service industries, it will be key for airline service providers to increase cost efficiency, including through the increased use of digitalization. The COVID-19 situation may permit growth opportunities for the original equipment manufacturers (OEMs) to increase their service business. This industry is subject to national FDI rules but in principle is not regarded as a critical industry and therefore generally not subject to increased FDI scrutiny. In case of supplier insolvencies, it will be challenging to divest the insolvent business without customer consent where there are non-assignment and non-subcontracting arrangements in place. In some European jurisdictions such consent can be overcome through a statutory demerger under universal successor doctrines. If local insolvency laws and circumstances permit a sale of the shares of the insolvent company, such consent will not be required. However, change of control clauses will always need to be considered.
The aircraft manufacturers are already a closed shop so there is very little room for consolidation. This may be different for their suppliers. The suppliers in the aviation industry will continue to be under price pressure so that the permanent consolidation will most likely continue. Whereas aircraft manufacturers have reached a critical mass that will protect them from insolvency through State aid, this may not apply for the supplier industry. In the case of supplier insolvencies, the same customer consent requirement and change of control problems may arise as with the sale of a service business of airlines (as stated above).
Ireland is recognized as a global hotspot for aviation financing and leasing, with an estimated fifty, sixty or even seventy percent. of the world’s leased commercial fleet being Irish owned. Leasing is one of the most common forms of aircraft ownership, whereby the company that ordered the aircraft sells it upon delivery into a lease structure, in which the company acts as the lessee.
These Irish aircraft leases are structured using a Special Purpose Vehicle (SPV), usually in the form of a Limited Liability Partnership (LLP), as the borrower. This enables the General Partner (who is for all intents and purposes the owner) to use the tax loss which arises in the LLP due to the depreciation of the aircraft, and apply it against their own corporation tax liability, without making itself liable for the LLP’s debts.
To fund these leases, LLPs take out loans from banks—Irish banks especially—secured on the aircraft. Banks typically lend 85% of the cost of the aircraft in the leasing arrangement, with the LLP providing only 15% equity.
Having provided 85% of the cost of each aircraft, the Irish banks are disproportionately exposed to the commercial aviation sector. This exposure is exacerbated by the quantities at stake—the cheapest Boeing aircraft costs around $100 million, whilst the most expensive Airbus costs just under half a billion dollars. An increase in bad debt related to these airplane leases therefore puts significant strain on the banks, especially if the market for the security (the aircraft), becomes illiquid or decreases in value substantially.
This creates an additional tier of risk for investors in Irish banks and Irish aircraft leasing LLPs. With an incomplete banking union in the Eurozone, Irish banks are dependent on the robustness of the Irish sovereign to support them when in need. Due to Irish banks’ extensive exposure under aircraft leases, a failure in the airline sector could trigger a need for government support—even for well capitalized Irish banks.
Could the exposure to aircraft leases cause a banking crisis in Ireland? And if so can the Irish government backstop its banks exposed under those leases?
A special thanks to Alasdair Marshall for his contribution to this publication.
 For more information, we refer you to Shearman & Sterling LLP, COVID-19: State Aid Support to Business, available at COVID-19--State Aid Support to Business.
 For more information regarding airline downgrades, we refer you to COVID-19: IATA Calls For $200bn In State Aid For Beleaguered Airlines.
 Although not specific to the aviation sector, companies can consult the dedicated Commission website and mailbox with any queries on whether anticipated competitor cooperation in light of the crisis would in fact infringe competition law rules—see Antitrust Rules And Coronavirus.
 For more information regarding the Temporary Framework, we refer you to Communication From The Commission.
 For more information regarding the European Commission released guidance on facilitating air cargo operations during the COVID-19 outbreak, we refer you to Communication From The Commission.
 The Civil Aeronautics Act of 1938 requires that U.S. citizens own or control at least 75% of the voting interests of U.S. airlines.
 Under Regulation (EC) No. 1008/2008 each member state is required to withdraw the operating license of an airline if such airline is under control of a non-EU person.
 Oral information received from the office of the German Slot coordinator.
 EU Regulation 2020/459 amending the EU Slot Regulation 95/93.
 For more information regarding the Commissions proposed measures to ease the impact of COVID-19 on the aviation industry and the environment, we refer you to Measures To Ease Impact Of COVID-19 On Aviation Industry.
 For more information on Irish aircraft leasing, we refer you to Ireland: Global Centre For Aircraft Leasing.
 For more information on Irish aircraft leasing, we refer you to Aviation Finance And Aircraft Leasing.
 For more information on Irish aircraft leasing, we refer you to The Irish Economic Miracle - Fact Or Fiction.
 See, e.g., About Airfinance Journal and Structuring Aircraft Financing Transactions which outline the common structure of aircraft leases. See also Bob Lyddon and Ewen Stewart’s article in Global Britain (footnote 3) for a detailed breakdown of lease structures.
 For more information on the average prices for Boeing aircrafts, we refer you to Average Prices For Boeing Aircraft As Of January 2019, By Type.
 For more information on the Airbus 2018 Price List, we refer you to Airbus 2018 Price List Press Release.