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24 March 2021
In its recent decision in AirAsia X Berhad v BOC Aviation Limited (Originating Summons WA-24NCC-467-10/2020), the high court held that a scheme of arrangement under Section 366 of the Companies Act 2016 is an insolvency-related event for the purposes of the Convention on International Interests in Mobile Equipment (the Cape Town Convention) and the Protocol to the Convention on International Interests in Mobile Equipment on Matters Specific to Aircraft Equipment (Aircraft Protocol).
The Cape Town Convention is an international treaty intended to standardise transactions involving movable property. Malaysia acceded to the convention and the Aircraft Protocol on 2 November 2005 and they both entered into force in Malaysia on 1 March 2006. The International Interests in Mobile Equipment (Aircraft) Act 2006, which was enacted to implement the convention and the Aircraft Protocol, came into force on 19 October 2006.
The Cape Town Convention creates international standards for the registration of contracts of sale, security interests and leases and provides legal remedies for default in financing agreements, including repossession and the effect of bankruptcy and insolvency laws. The convention's primary aim is to resolve the problem of obtaining certain and opposable rights to high-value aviation assets – namely, airframes, aircraft engines and helicopters which, by their nature, have no fixed location. This problem arises primarily from the fact that legal systems have different approaches to securities, title retention agreements and lease agreements, which creates uncertainty for lending institutions regarding the efficacy of their rights. This hampers the provision of financing for such aviation assets and increases borrowing costs.
The key points of the high court's decision are as follows:
Pursuant to an application under Section 366 of the Companies Act 2016, AirAsia X Berhad (AAX) applied for leave from the high court to convene a creditors' meeting for the purpose of considering and approving a proposed scheme of arrangement (leave application). Under the proposed scheme, AAX's liabilities of RM64.15 billion would be written down to RM200 million to be shared equally with its scheme creditors, resulting in a cram down in the form of a 99.7% haircut.
Subsequently, 15 creditors obtained leave from the high court to intervene, including Malaysia Airports (Sepang) Sdn Bhd (the operator of the Kuala Lumpur International Airport), aircraft lessors and Airbus SAS.
The classification of scheme creditors changed three times following the filing of the leave application (for further details please see "Landmark decision on first airline debt restructuring scheme due to COVID-19"). The latest classes of scheme creditor at the hearing of AAX's application were secured Class A creditors (creditors of AAX having security over its assets) and unsecured Class B creditors (creditors which had unsecured claims against AAX).
The aircraft lessors were treated by AAX as "creditors of AAX having security over the assets of AAX" and placed in Class A with the secured lenders. It was argued on AAX's behalf that the aircraft lessors were secured creditors by virtue of the security deposits and maintenance reserves which they held.
Scheme of arrangement is insolvency-related event for purpose of Article XI(10) of Aircraft Protocol
The high court agreed with the aircraft lessors that a scheme of arrangement under Section 366 of the Companies Act 2016 would fall within the definition of an 'insolvency-related event'(1) for the purpose of Article XI(10)(2) of the Aircraft Protocol.
First, the court noted that there had been two recent cases (the Irish High Court case of Re Nordic Aviation Capital Designated Activity Company(3) and the High Court of England and Wales case of Virgin Atlantic Airways Limited(4)) in which the courts had come close to determining the question of whether a scheme of arrangement or restructuring plan is an insolvency-related event for the purposes of the Aircraft Protocol. However, in the end, the question was not necessary for those decisions as the creditors in question had approved the scheme of arrangement and the restructuring plan.
The recent case involving MAB Leasing Ltd was also not conclusive nor of guidance as it did not decide the issue of the convention since no objection was raised by any of the creditors.
Second, based on the principles relating to the interpretation of treaties, the issue of whether a scheme of arrangement is an insolvency proceeding must be considered based on principles underlying the Cape Town Convention and not on national law.(5) While the Official Commentary of the Cape Town Convention does not address the issue as to whether a scheme of arrangement is an insolvency proceeding under the convention, the Annotation to the Official Commentary on the Cape Town Convention of 16 June 2020 – endorsed by Professor Sir Roy Goode, author of the definitive guide to the Cape Town Convention – confirms that schemes of arrangement fall within the definition of 'insolvency proceedings' under the convention where they are:
The annotation also confirms that a reorganisation arrangement, in which a court acts to facilitate a statutory process and where the court's approval is required for its implementation, constitutes an insolvency proceeding where the debtor's assets and affairs are subject to court control or supervision for the purposes of reorganisation.
Third, the high court opined that Payne's expert opinion on the Cape Town Convention produced and relied on by AAX put too restrictive a meaning on the words "in which the assets and affairs of the debtor are subject to control or supervision by a court", as provided for under Article 1(I) of the convention. According to Payne, three elements are required in order for a scheme of arrangement to be an insolvency proceeding for the purpose of Article 1(l) of the convention – namely:
Payne's view is that in a scheme of arrangement, the debtor's assets and affairs are not subject to court control or supervision because outside the terms of the scheme of arrangement, the directors can continue to manage the company without court approval.
The high court held that Article 1(l) does not state that the entire assets and affairs of the debtor must be covered by the scheme. Neither does it matter that outside the scheme, possession and management of the company remain with the management. All that is required is that the proceedings being collective proceedings is such that they involve assets and affairs of the debtor being subject to court control or supervision. The high court was also of the view that the fact that a proposed scheme must be approved by the court meets the requirement of "control or supervision by a court".
The high court also considered the Gibbs rule,(6) argued by some of the lessors. The Gibbs rule is an English common law principle which provides that a debt governed by English law cannot be discharged or compromised by foreign insolvency proceedings.
The high court held that the Gibbs rule does not restrict the court from entertaining and, if it deems fit, approving a scheme of arrangement which involves the discharge or modification of any contractual rights between the scheme company and its creditors even where the contracts are governed by English law or other foreign laws. This was the approach adopted by the Singapore High Court(7) and the Australia Supreme Court,(8) which rejected the rule.
Cape Town Convention applies to both rights in rem and rights in personam
The high court disagreed with AAX's submission that the Cape Town Convention was never intended to regulate rights in personam that a creditor might have against a debtor (eg, lease rentals and termination compensation).
Article XI(10) of the Aircraft Protocol was found to be unambiguous; thus, the words "obligations under the agreement" in Article XI(10) thereof must be given their literal, ordinary and natural meaning. In this regard, there can be no doubt that the words must include the debtor's obligation to pay rent under the agreement. To restrict the meaning of the words 'obligations' to obligations relating to in rem matters would read into Article XI(10) of the Aircraft Protocol words which are not there. There is nothing to suggest that the convention is to be viewed narrowly to extend only to rights in rem.
The word 'obligations' also appears in Article XI(7)(9) of the Aircraft Protocol, where there is little doubt that it must include the in personam obligation to pay rent under the agreement. The high court held that it would be "incongruous" for the same word in Article XI(10) of the protocol to bear a different and narrow meaning, as suggested by AAX.
The prohibition under Article XI(10) preventing a debtor from modifying the obligations under the agreement without the creditor's consent was found to be consistent with the purposes of the Cape Town Convention (ie, to promote and reduce the costs of asset-based financing for airline equipment).
AAX does not require lessors' consent in respect of cram-down provision under proposed scheme
While the high court agreed with the lessors that the Cape Town Convention applies to both in rem and in personam rights and that a scheme of arrangement under Section 366 of the Companies Act 2016 falls under the definition of an 'insolvency-related event' under the Aircraft Protocol, it was nevertheless of the view that in the present case, AAX did not require the aircraft lessors' consent in respect of the cram-down provision under the proposed scheme.
Reading Article XI(7), (10) and (11) together, the high court held that Alternative A of the Aircraft Protocol applies only where the debtor chooses not to terminate the lease agreement when an insolvency-related event occurs or when the creditor does not exercise its right to repossess the aircraft. In such situations, the obligations under the lease agreement, including the obligation to pay rent, cannot be modified by the debtor without the creditor's consent.
Aircraft lessors are not secured creditors
The aircraft lessors of 27 aircraft leased to AAX's leasing subsidiaries were originally considered by AAX as unsecured creditors. This status was subsequently changed to secured creditors. It was disclosed that the ground for this change was the security deposits and maintenance reserves paid over by AAX to the lessors pursuant to their respective lease agreements.
The high court held that AAX could not treat the lessors which had paid the security deposits and maintenance reserves as secured creditors as they did not fall within the definition of 'secured creditors' under Section 2 of the Insolvency Act 1967, which defines a 'secured creditor' as a person holding a mortgage, charge or lien on the property of the debtor or any part thereof as security for a debt due to it from the debtor, but does not include a plaintiff in any action which has attached the property of the debtor before judgment.
Another factor which the high court opined militated against AAX's position was the fact that AAX had no proprietary rights over the security deposits and maintenance reserves once they were paid to the lessors. It was noted that the lessors had in most cases commingled the cash payments with their own funds as is provided in a typical clause relating to security deposits and maintenance reserves in lease agreements. There was no issue of commingling of any security interests as the lessors had never had any security interest in the security deposits and maintenance reserves. The high court agreed with the lessors that the right of disposal of the security deposits and maintenance reserves was no longer with AAX. All that AAX had was a contractual right on the termination of the lease agreements to be paid equivalent sums or a balance sum if it had met all of its obligations under the agreements. The fact that the lease agreements provided that the security deposits were "security for the performance of the agreement" did not assist AAX's position any further.
This is an interesting case which will likely be instructive in many jurisdictions as the number of airline restructurings continues to rise due to COVID-19's impact on the aviation industry.
For further information on this topic please contact Sharon Chong or Janice Ooi at SKRINE by telephone (+603 2081 3999) or email (firstname.lastname@example.org or email@example.com). The SKRINE website can be accessed at www.skrine.com.
(1) An 'insolvency-related event' is defined in Article I(2)(m) of the Aircraft Protocol as the commencement of insolvency proceedings or the declared intention to suspend, or actual suspension of, payments by the debtor where the creditor's right to institute insolvency proceedings against the debtor or to exercise remedies under the Cape Town Convention is prevented or suspended by law or state action.
(3)  IEHC 445. In this case, while arguments were put forward by the company that a scheme of arrangement consists of restructuring of only certain parts of a debtor's assets and does not constitute an insolvency-related event for the purposes of the Cape Town Convention, the Irish High Court held that it was unnecessary to consider or even make a ruling on the potential issues arising under the Cape Town Convention as the scheme in question was ultimately approved by both classes of creditors unanimously.
(4)  EWHC 2191 (Ch). In this case, the question of whether a cram down of non-consenting creditors pursuant to a restructuring plan would contravene the Cape Town Convention was again not decided as Virgin had secured the consent of all convention creditors prior to the hearing.
(6) Anthony Gibbs and Sons v La Société Industrielle et Commerciale des Métaux (1890) 25 QBD 399 (CA), recently reinforced by the English Court of Appeal in Re OJSC International Bank of Azerbaijan  EWCA Civ 2802 (CA).
The insolvency administrator or the debtor, as applicable, may retain possession of the aircraft object where, by the time specified in paragraph 2, it has cured all defaults other than a default constituted by the opening of insolvency proceedings and has agreed to perform all future obligations under the agreement. A second waiting period shall not apply in respect of a default in the performance of such future obligations.
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