The Commercial Implications of the Virgin Australia Ruling

[In The News]

DALLAS – As the pandemic transitions into an endemic, it seems things may finally be turning around for the global airline sector. 

According to the International Air Transport Association (IATA), industry losses are expected to drop to US$9.7bn—significantly less than the collective US$42.1bn loss of 2021. As an added bonus, the association believes the industry will return to profitability in 2023. 

That said, the impact of the past few years has unquestionably left a lasting mark on the sector. A recent High Court of Australia decision regarding Virgin Australia (VA) and its lessors is a prime example.

The decision was based on a dispute about repatriation costs that occurred after VA went into administration in 2020. Essentially, a lessor argued the airline (or, in this case, the bankrupt estate) was liable for the cost of return of its engines. The estate argued that, given the circumstances, the contractual lease terms should not apply.

Ultimately, the court sided with the estate—setting a new precedent that will likely have ongoing implications for lessors and airlines and inspire a new approach to conducting business.

As the appointed administrator to VA, Deloitte acquired valuable insights into this case, the reasoning behind the ruling, and the commercial implications for the industry. Here, we share some of these “lessons learned” to help lessors and airlines adapt to this new landscape.

Photo: Misael Ocasio Hernandez/Airways

The Backstory

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When the pandemic hit in 2020, and VA was forced to ground its 144 planes, the company was not in a strong cash flow position, saddled as it was with AU$7.5bn in debt. So, after a short period of attempting to gain support from shareholders, debt and equity markets, and governments, the directors appointed Deloitte as administrators under the Australian Corporations Act. 

It should be noted that, in Australia, bankruptcy is not a court-led process. As administrators, we have day-to-day operational control and take on the directors’ powers—although we may go to court for directions from time to time. That said, most of the decisions regarding operations, and importantly a power of sale, vest with us.  

When we assumed the role, therefore, we immediately launched a dual-track process—with the aim of selling and restructuring the business. This was a very rapid process (due to lack of available cash) and highly competitive, with five parties short-listed for more extensive due diligence.  

As we moved through the process, we had to keep a few things in mind:

1. Aircraft leasing was crucial. If Virgin Australia had no planes, there was essentially no airline, so relationships with lessors were paramount.

2. The rules that determine the disposition of “aircraft objects” are governed by the Cape Town Convention on a global basis (at least for those countries signed to it, which are most of them, including Australia). That meant we had to keep the Cape Town Convention top of mind.

3. To operate the airline and have enough cash to meet ongoing operating costs, we needed as much “rent-free” time as possible. So we made a court application to extend the “rent-free” period under the Australian Corporations Act from seven days to 60, then 90, days (which was the time set out in the Cape Town Convention). 

During this 90-day extension, we negotiated “power by the hour” arrangements with VA’s lessors. Essentially, we agreed to insure, park, maintain, and certify their aircraft—but we could only pay for use, based on the flying time for each aircraft or engine.  

As this was in the middle of COVID, when most airlines were grounded and there was extreme uncertainty around when (or if) airlines would fly again, the market for aircraft was decimated. As a result, most of the lessors agreed to this arrangement, as it provided some measure of cost coverage, preservation of aircraft, storage, and the opportunity to participate in the VA restructure, at a time when the secondary market for aircraft was considered very poor.  

However, one lessor wasn’t on board with this arrangement—and this disagreement ultimately led to the dispute.

Virgin Australia VH-XFE A330-200. Photo: Christian Winter/Airways

The Thinking behind the Ruling

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Because our process was guided by both the Cape Town Convention and the Australian Corporations Act, some of the language governing the transaction was open to interpretation. As such, the lessor was able to argue that the contractual terms should apply, and the bankruptcy estate should pay what was owed for the associated engines. 

This would have been devastating to the potential restructuring of the business—as it would have significantly impacted the airline’s other lessors and creditors. If other lessors made the same argument, they would gain priority in the administration—ultimately wiping out the pool of funds, leaving nothing for other creditors. 

There would also be broader implications. Specifically, if the lessor’s position was correct, any time an airline declared bankruptcy in a jurisdiction that had adopted the Cape Town Convention, the trustees or administrators could become immediately liable for significant repatriation costs for the return of the aircraft. This would make airline restructures around the world much more complicated, and likely result in an influx of airline closures.  

Happily, the court ruled in favor of the estate and the funds have been retained to be distributed to creditors. Now, the airline industry has a global precedent that hopefully will make future restructurings more efficient.  

Virgin Australia VH-XFG Airbus A330-243. Photo: Brandon Farris/Airways

The Final Result

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After a short restructuring of the business, and creditor approval of the deal, Bain took control of the business in November 2020. Bain continues to own the airline, which remains the #2 carrier in Australia. 

The deal won the “International Turnaround of the Year” award from the Turnaround Management Association, as well as “Restructuring Deal of the Year” in Australia, by successfully demonstrating how a formal administration/bankruptcy procedure can work in these situations. Hopefully, it can become a future standard for approaching restructures and working with stakeholders.  

Yet this decision unquestionably changed how lessors and airlines will conduct business moving forward. Specifically, lessors would be well-served to:

• Be wary of the costs (and time) associated with repatriation, when considering recovery situations. In many cases, it can make more sense to leave the aircraft with a bankruptcy trustee/administrator to see how a bankruptcy plays out, rather than seize aircraft straight away. It may be possible to negotiate an equally beneficial deal with a new owner, so don’t close down the options too early.  

• Re-evaluate pricing models. Given the costs lessors may have to bear in the event of default, leasing rates may need to rise to mitigate the risk.

• Work with bankruptcy trustees/administrators. These individuals are trying to find an outcome that will allow the business to continue, which is in everyone’s interest. Simply diving in and retrieving leasing equipment runs counter to this objective—and can ultimately be a costly strategy.

• Be open to a wide range of options. There is a range of options lessors can consider to retain value, such as taking equity in airlines or their spin-offs following a restructuring.

VIRGIN AUSTRALIA VH-YFZ BOEING 737-800. Photo: Noah Pitkin/Airways

Moving Forward

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While the VA ruling is one example of how things have changed since the onset of the COVID pandemic, it also has the potential to improve things for the better, particularly if lessors adapt their business practices to meet today’s new challenges.

Moving forward, as lessors are large stakeholders in restructurings, we will likely see much more varied options being pursued to make restructurings successful —which, in turn, could benefit both the industry at large and its individual players by preserving value, which is what restructuring is all about.

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Article written by analysts at Deloitte Aviation, whose team helps companies create competitive advantages across their businesses. Featured image: Virgin Australia V Australia VH-VPF BOEING 777-3ZG(ER). Photo: Brandon Farris/Airways

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