We have recently received numerous queries from clients on security deposit arrangements in aircraft leases. This note looks at key drafting often found in these arrangements and the function of that drafting under English law.
The technicalities of taking cash collateral are something of a nerd's paradise for some lawyers. However, this note aims to take a high-level, practical approach and does not dwell on arcane issues that are often of marginal real-world relevance. In addition, this note does not discuss taking a standby letter of credit instead of a security deposit (a Deposit).
Outright title transfer to the Deposit
The Lessee makes an outright transfer of the Deposit to the Lessor, who holds the Deposit as its sole legal and beneficial owner. The idea here is not for the Lessor to take security over the Deposit, but to become its sole owner instead. This tends to mitigate, avoid or simplify many of the technical issues that can arise when creating security over cash collateral (e.g. under a security assignment or charge). These issues include:
- whether the security has priority over claims to the Deposit of an insolvent Lessee's other creditors;
- whether the security needs to be registered or notified under English law or in the Lessee's jurisdiction of incorporation, and whether other formalities, such as notarisation, have to be followed;
- conflict of laws issues;
- the enforcement process; and
- whether any documentary taxes must be paid in respect of such security.
Another advantage of this sort of arrangement is that taking cash collateral via an outright title transfer is common in certain capital markets, derivatives and trading transactions in many global financial markets. Consequently, the laws of many states recognise well-documented title transfer cash collateral arrangements.
The Lessor can hold the Deposit as it sees fit: in a dedicated account, or in a general account where it co-mingles with the Lessor's other funds. Among other things, this:
- reinforces the analysis that the Deposit is the Lessor's sole legal and beneficial property in which the Lessee has no interest of any kind;
- tends to negate any argument that, contrary to the express agreement of the parties, the Lessor holds the Deposit as a trustee for the Lessee, or in another fiduciary capacity;
- saves the Lessor the trouble and expense of running a dedicated bank account for the Deposit; and
- would usually make it even more difficult than it would otherwise be for an insolvency officer of the Lessee to point to any given credit balance on any bank account of the Lessor as being the Lessee's property and arguably available to the Lessee's other creditors.
From an English law point of view, we would usually recommend that the Lessor actively co-mingle the Deposit with its other funds and not just rely on its rights under the lease to do so.
Lessee may grant Lessor a back-up security interest over the Deposit and related rights
This is not an essential feature of most title transfer cash collateral arrangements. However, it may sometimes be prudent if:
- it is possible that not all disputes regarding the Deposit will be settled before the English courts, but may be litigated in the Lessee's jurisdiction (e.g. because, among other things, the lease does not contain a two-way exclusive jurisdiction clause in favour of the English courts); or
- the Lessor is not satisfied with the outright title transfer wording the lease contains in respect of the Deposit (e.g. because it holds the Deposit pursuant to a novated lease under which the Lessor has had to accept loose wording from the original lease).
Sometimes leases contain short-form, generic wording purporting to create such a back-up security interest. This drafting will not necessarily create security that will be effective or practically useful in all relevant jurisdictions. However, short-form, generic wording is all that is required under some states' laws.
Another consideration is that back-up security wording could create the impression that the Lessor is not confident that it is the sole legal and beneficial owner of the Deposit under an effective title transfer cash collateral arrangement.
Lessor may, but Lessee may not, dispose of or create security over the Deposit
As well as further reinforcing the analysis that the Deposit belongs to the Lessor only, this drafting aims to protect the Lessor's enforcement rights (discussed under the next three headings). If the Deposit is free from security and from other interests in favour of third parties, the Lessor can be more confident that it can freely enforce against the Deposit on a relevant Lessee default.
This drafting will usually also make it clear that the Lessor may (among other things) assign the Deposit by way of security to its financier(s).
Lessor may apply or set off against the Deposit in an enforcement
As with other English law cash collateral arrangements where the cash is held by the creditor itself and the amount of the debtor's obligations is quantified, enforcement is usually a simple self-help process. In most cases, the Lessor simply updates its internal accounting records to apply the Deposit to the Lessee's obligations. If (on a particular transaction) the Deposit had not been co-mingled with other Lessor funds, but had been held in a dedicated account, the Deposit should also usually be transferred into one of the Lessor's general accounts on enforcement. The drafting should also be clear that the Lessor does not have to give the Lessee advance notice that it is exercising its enforcement rights in respect of the Deposit.
The above process can be further simplified by giving the Lessor the express power to value unquantified Lessee liabilities in a commercially reasonable manner for the purpose of enforcing against the Deposit. If appropriately worded, this or similar drafting would normally entitle the Lessor to quantify unliquidated Lessee liabilities in order to apply the Deposit to those liabilities – and to do so without having to go to court. Sometimes a Lessee would be able to challenge such a valuation (e.g. on the basis it had been made perversely or in bad faith). However, it would often be difficult for a Lessee to bring such a challenge (e.g. if it were in insolvency proceedings and its limited funds were required for other matters, or its insolvency officer were unwilling to embark upon risky legal proceedings).
Lessor not obliged to refund the Deposit itself
This is to be consistent with the Deposit being the Lessor's property, rather than belonging to the Lessee and merely being subject to security given by the Lessee.
Lessor pays Lessee an amount equal to any post-enforcement surplus Deposit instead
The Lessor obviously should not profit by retaining any surplus funds it holds after enforcement against the Deposit. However, for further consistency with the Lessor being the sole owner of the Deposit, the Lessor cannot be under an obligation to refund any part of the Deposit itself. Therefore, the Lessor must instead pay an amount to the Lessee that is equal to the Deposit, less all amounts (if any) towards which the Lessor has applied the Deposit on enforcement. This payment becomes due on a given date (the Relevant Date) falling after the lease expires, or after any enforcement process resulting from an earlier lease termination has completed.
Lessee has no intermediate rights to or in respect of the Deposit
The robustness of the arrangements summarised in this note will generally be greater if they provide (expressly or by implication) that the Lessee has no right:
- to require that the Deposit be applied for any other purpose than to satisfy the relevant obligations of the Lessee under the lease; or
- to call for any payment to be made to it in respect of the amount of the Deposit before the Relevant Date.
- For brevity, in this note the term "Deposit" includes to any type of right or interest in, to or in respect of, the Deposit.↩