With an Uncertain Future, Airline Bankruptcies Are Up in the Air
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The airline industry is enduring one of its worst crises, with second quarter results the worst ever and the third quarter not expected to be any better. Bankruptcies are likely on the horizon for some U.S. carriers. To learn more about what that process may look like, GLG spoke with Mark Berman, a former partner at Nixon Peabody LLP who is currently an adjunct professor at Northeastern University. Following are a few select excerpts from our broader discussion.
Can you help us understand the precedent that exists for major U.S. airline Chapter 11s, like Delta in 2005 and American in 2011?
The airline industry is certainly familiar with Chapter 11. Virtually every major U.S. airline, except for JetBlue and Southwest, have gone through a bankruptcy proceeding of one type or another over the past four decades. However, each airline Chapter 11 stands on its own. Each had particular circumstances that led to the Chapter 11 filing, and those particular circumstances often dictated the type of reorganization or liquidation that took place. Some resulted in mergers or acquisitions, others in liquidations.
Delta Airlines used its Chapter 11 case to significantly reduce its operating costs, primarily in the labor area. Using Section 1113 of the Bankruptcy Code, Delta was able to renegotiate its collective bargaining agreements and, thereby, reduce its current employment costs. It also used Section 1114 of the Bankruptcy Code to restructure its OPEB (other post-employment benefits) obligations. The airline also took advantage of the 2006 modification of pension laws that allowed it to catch up on payments due on its defined benefit pension plan. Delta also restructured its fleet as it got rid of a lot of unprofitable routes, added international routes it viewed as much more profitable, and returned it to an operating profit. Delta ultimately cut its debt by $7.6 billion, about half of its outstanding debt at that time. In Delta’s plan of reorganization, which was not unusual for an airline Chapter 11, existing stockholders got wiped out. Unsecured creditors received some of the new equity issued under the plan, but old equity got nothing. Delta’s exit financing was $2.5 billion, of which $2.1 billion was used to repay the debtor-in-possession financing facility, with the other $0.4 billion used to pay administrative expenses incurred during the Chapter 11 case.
The American Airlines Chapter 11 couldn’t have been more different as American was able to acquire US Airways, the most unusual aspect of the proceeding. American’s unsecured creditors received stock in the reorganized company, as did the stockholders of US Airways. Otherwise, the company went through much the same type of operational restructuring that Delta did. American updated its fleet by rejecting certain leases, acquired or restructured other leases, and sold off some equipment while acquiring other equipment that it thought was more valuable or represented operational advantages. American also renegotiated its collective bargaining agreements, jettisoned a bunch of facilities that the airline no longer required by rejecting those facility leases, or renegotiated other facility leases using the threat of rejection to strengthen its negotiating posture. It also expanded its international flight schedule and emerged from Chapter 11 as a larger and profitable airline.
Both the Delta and American Chapter 11 proceedings are generally considered successes.
Most airline Chapter 11 proceedings have followed the Delta model. In other words, Chapter 11 is used to restructure costs by updating fleets, getting rid of unprofitable routes, acquiring more profitable routes, cutting labor costs by renegotiating employment and collective bargaining agreements, restructuring OPEB, getting rid of unprofitable facilities, and then structuring a plan of reorganization where new equity is used as the major way to satisfy unsecured creditors while old equity is eliminated.
How much can we look at these examples when examining the airline space today?
Ultimately, we will get to the restructurings, but it’s way too early to do that. In order to successfully restructure an airline, you need a clear picture of the future, and that’s something that nobody has right now. The airline industry is certainly not yet in a position where it knows when the flying public will return and how strong that return will be. The most recent report I’ve seen shows about a 66% decline in the anticipated travel needs going forward through the end of the year. It’s certainly not a rosy picture. An inability to see the future leads to an inability to take the steps necessary to return the airline to a profitable operation. Just what size operation is appropriate and can be sustained? And without the ability to envision what future operations should look like, there’s difficulty in valuing the airline business. Valuation of the business is needed in order to know how that value is to be distributed throughout the airline’s capital structure. So, the inability to right-size operations or to value the resultant business means the bankruptcy proceedings are likely to remain in a holding pattern and will go forward only once there is clarity about the future.
In the case of a U.S. airline bankruptcy, will executory contracts be assumed or rejected?
As a general proposition, a debtor in a bankruptcy proceeding has a right, under Section 365 of the Bankruptcy Code, to get rid of (i.e., to reject) virtually any kind of incomplete (i.e., executory) contract or unexpired lease, a contract or lease where there’s still performance to be rendered by both sides, as long as the debtor can satisfy the Bankruptcy Code standard that the contract or lease is burdensome. That’s an incredibly easy standard for an airline to meet. In my 39 years of bankruptcy practice, I saw only one instance where a court refused to allow a business in Chapter 11 to reject an executory contract or unexpired lease. In all other instances, the bankruptcy court granted the debtor’s request to reject an executory contract, thereby relieving the debtor from any ongoing operational obligations associated with the executory contract or unexpired lease after rejection. That’s one of the major ways that a company in Chapter 11 reduces its ongoing operational expenses, so that it can turn a loss operation into a profitable one as a prelude to proposing a plan of reorganization by which to emerge from Chapter 11.
There is an exception, though, for aircraft equipment, including aircraft engines. Ordinarily, a debtor in Chapter 11 can decide to reject an executory contract or unexpired lease anytime during the Chapter 11 case. But for an airline, aircraft equipment and vessels are subject to Section 1110, which forces a debtor in a Chapter 11 proceeding to make a decision on rejection within 60 days after the case begins. Basically, it gives the lessor of aircraft equipment or of the airplane itself, as well as creditors with a security interest in aircraft equipment or the airplane, a pressure point in negotiations with the debtor. Today, many of these leased airplanes are just sitting on a distant portion of the tarmac or in the desert. Assuming the lessor doesn’t have any other use for the aircraft, including leasing it to another airline, the lessor is not in a very good negotiating position and would likely be satisfied if the airline simply pays the ongoing cost of maintaining that aircraft in its stored state while the parties agree to extend the 60-day deadline. If the airline has a current need for the equipment, the lessor or secured party will expect to be paid for that ongoing use.
Any ideas of the speed with which an airline will be able to go through this process, assuming creditors are willing to work with them, and things are relatively normal?
In a relatively normal context, i.e., pre- or post-pandemic, I’d estimate that a Chapter 11 for a major airline would take somewhere between a year and a half to three years to pull off, with a lot having to do with whether labor negotiations are a key feature in the restructuring, as those tend to take a long time to work out. The trouble is, as I said before, in today’s airline world, there’s a significantly reduced ability to predict the future. How do you know what your future employment levels and costs should be when you don’t know what the future will look like? Which routes will be profitable? As a result, there’s currently little ability to sit down with labor and have a renegotiation of those collective bargaining agreements. If an airline were to file a Chapter 11 case now, I expect you would see a file-and-hold type of process as we await some clarity about the future of airline travel.
Following Chapter 11, are there any anomalies regarding a bankrupt airline merging with another carrier?
A debtor airline that emerges from Chapter 11 with a less-leveraged balance sheet as a result of the conversion of debt into equity can be a strong merger candidate. It will likely have in place an upgraded fleet, an improved route system, and a reduced operating cost structure. It wouldn’t surprise me that an airline coming out of Chapter 11 could become a magnet for a merger if there is another airline looking to complement its own route structure with that of the reorganized airline, and vice versa.
Are there any other factors of the bankruptcy process that we need to consider?
I haven’t focused in this discussion on valuation, which is at the heart of most Chapter 11 cases. Valuation of collateral is a key feature when considering what a secured party is entitled to both during the case as well as under the plan of reorganization. During the case, if the value of the collateral declines, the secured party is entitled to be adequately protected for that decline, which usually means that the debtor will be making payments during the case to the secured party equal to that decline in value. And in the context of a reorganization plan, every level in the capital structure of the business is entitled to be paid in full (with either cash or property, including with equity of the reorganized company) before those lower on the capital structure get anything. So, valuation of the reorganized business is critical to knowing how that value will be distributed throughout the capital structure. If an airline were to be restructured in Chapter 11 now, a fight over valuation would likely ensue and a low valuation based upon currently depressed operations would likely wipe out not only current equity, but also most if not all unsecured creditors.
About Mark Berman
Mark Berman is a Retired Partner at Nixon Peabody LLP now teaching business and law courses at Northeastern University in Boston. His legal career included work for debtors and creditors as a traditional bankruptcy attorney handling complex workouts and Chapter 11 reorganizations, restructuring municipal debt under Chapter 9, and liquidations either under Chapter 7 or out of court. He also applied his bankruptcy expertise to transactions involving the securitization of various revenue streams as well as all manner of public, leveraged, and project finance. In a career spanning 39 years, Mr. Berman represented virtually every kind of interest that might be involved with a financially troubled business, municipality, or individual. In supporting transactional efforts, Mr. Berman regularly writes and speaks on bankruptcy, commercial, and public finance law subjects and has co-authored a handbook on second lien financing and intercreditor agreements published by the American Bankruptcy Institute.
This airline industry article is adapted from the October 7, 2020, GLG teleconference “U.S. Airline Bankruptcy Scenarios.” If you would like access to the full teleconference transcript or would like to speak with airline industry expert Mark Berman, or any of our more than 700,000 industry experts, contact us.