Although certain readers’ eyes glaze over “boilerplate” choice of law provisions, the choice of law and the enforcement of choice of law for an aircraft lessor may have substantive economic consequences. For example, under U.S. commercial law, a lease with a nominal purchase option is characterized as a “non-true lease,” the commercial law equivalent of a secured acquisition financing. The implications for the lessor of that characterization when a lessee declares bankruptcy are significant and mostly adverse. However, as discussed in a recent California Bankruptcy Court memorandum of decision (the “Memorandum”)¹, a conflicts of law determination by the court allowed the aircraft lessor in that case to avoid a recharacterization of its leasing transaction due to its choice of English law and the court’s application of English law in its decision.

The Lease Financings

Zetta Jet USA, Inc. (“Zetta USA”) was an aircraft charter operator based in the United States, providing charter flight availability for both domestic and international travel. Zetta Jet PTE, Ltd. (“Zetta Singapore”) and Zetta USA (the “Debtors”) filed Chapter 11 petitions in a U.S. Bankruptcy Court in California, and the cases were ultimately converted to Chapter 7.

Prior to filing its Chapter 11 petitions, the Debtors entered into purchase and lease financing transactions (the “Leases”) involving four Bombardier Global 6000 Aircraft (the “Aircraft”) with CAVIC Aviation Leasing (Ireland) 22 Co. Designated Activity Company (“CAVIC”) and Bombardier Aerospace Corporation (“Bombardier”). The transactions contemplated CAVIC’s purchase and lease of the Aircraft to the Debtors, including by making progress payment advances (the “PDP Advances”) to cover the Debtors’ progress payment obligations to Bombardier under the aircraft purchase agreement during the completion and pending delivery of the Aircraft. Upon delivery of the Aircraft by Bombardier, and CAVIC’s payment of the balance of the purchase price to Bombardier, the Debtors agreed to accept each of the Aircraft under the related Leases, and pay the rent and other amounts, without abatement for the entire term of each of the Leases.

 The economic terms of the Leases, including the scheduled rent, any prepayment amount and the lease term, were calculated so as to repay CAVIC for its entire investment in the related Aircraft. Specifically, the rent and other amounts, if paid as and when due under the Leases, would result in CAVIC’s being repaid, in full, the PDP Advances as well as the balance of the purchase price, together with interest at an agreed rate. Accordingly, although the transactions were documented as “leases,” the economics of each were essentially the same as what might be expected if the transaction was documented as a secured loan financing. Only three of the four Leases involved Aircraft that had actually been delivered and accepted under those Leases.

The Trustee’s Characterization Claims

The Chapter 7 bankruptcy trustee (the “Trustee”) filed a complaint in the bankruptcy case against CAVIC and Bombardier (the “Complaint”) seeking, among other things, a declaratory judgment that the Leases were financings, and not true leases. CAVIC filed a motion (the “Motion”) to dismiss certain counts of the Complaint, and the Trustee filed an opposition to that Motion (the “Opposition”). After considering the arguments by CAVIC and the Trustee, the court dismissed the referenced counts of the Complaint with leave to amend, for the reasons discussed below.

The Related Issues

In order to rule on the Motion and Opposition, the court had to consider, analyze and reach conclusions regarding the following issues: “1) what choice of law rules apply; 2) based on the applicable choice of law rules, which law applies; 3) whether the Trustee can be bound by a choice of law provision; and 4) what the recharacterization requirements are under the applicable law.”² 

Choice of Law Rules

The Trustee argued that California’s version of the Uniform Commercial Code (“UCC”), specifically, UCC § 1-301, was the appropriate choice of law rule for this matter, and that contractual choice of law provisions may be disregarded when considering issues arising under Article 9 of the UCC.³  CAVIC disagreed and argued that Article 9 of the UCC is not a choice of law provision, and that instead the court should look to controlling Ninth Circuit precedent⁴. CAVIC cited a number of Ninth Circuit and related cases as support for its argument that federal common law choice of law rules apply in Ninth Circuit bankruptcy cases,⁵ and that federal common law applies § 187 of the Restatement (Second) of Conflict of Laws (the “Restatement”) to determine the enforceability of contractual choice of law provisions.⁶

The court agreed with CAVIC’s argument and in accordance with Ninth Circuit precedent, applied Restatement § 187. In particular, the court noted that under Restatement § 187, the parties’ choice of law “will be applied if the particular issue is one which the parties could have resolved by an explicit provision in their agreement directed to that issue,”⁷ and that “parties may agree to apply the law of a forum to decide all questions regarding the construction and performance of an agreement, but not questions regarding capacity to contract, or ‘other contract-formation issues’.” If parties wish to choose the law to govern contract formation issues, the parties would need to show, if that choice is challenged, a reasonable relationship to the state chosen.

Surprisingly, the Memorandum did not address the applicability of the Convention on International Interests in Mobile Equipment (the “CTC”) and the Protocol to the Convention on International Interests in Mobile Equipment on Matters specific to Aircraft Equipment (the “Cape Town Protocol”, and together with the CTC, the “Cape Town Treaty”). Both the United States and the United Kingdom have adopted and implemented the Cape Town Treaty, and in their respective declarations specifically consented to the applicable of Article VIII of the Cape Town Protocol. Article VIII expressly allows contractual choice of law by the parties to agreements covered by the Cape Town Treaty, including agreements purporting to constitute leases, however characterized. Perhaps, if the court had considered and applied Article VIII when determining whether to uphold the governing law provisions in the Leases, it might have expedited its analysis because the support for such provisions in the Cape Town Treaty would have preempted any contrary statutory or common law considerations raised by the parties in their pleadings.

Based on the Applicable Choice of Law Rule, Which Law Applies?

The court noted that “it is undisputed that the parties selected English law to govern” the pertinent transaction documents, and that “the parties who executed the relevant documents were sophisticated and well-represented; there are no allegations that any party lacked the capacity to contract or that a binding contract was not formed.”⁸ Applying Restatement § 187, the court determined that English law, which was agreed to by the parties, must be applied because the contract formation or validity was not in dispute.

Although the Trustee cited an opinion by a Pennsylvania bankruptcy court as support for his argument that UCC §§ 1301, 9301 and 1203 displace extraterritorial contractual choice of law clauses regarding recharacterization of a lease under UCC Article 9, the court did not find that case to be persuasive.⁹ The court distinguished that opinion from the circumstances of this case noting that the parties in that case agreed that Pennsylvania choice of law rules governed, but “the relevant documents in this case contain no indication of which choice of law rules govern, and the applicable choice of law rule is the Restatement (Second), which requires application of English law.”¹⁰  

Do Choice of Law Provisions Apply to the Trustee?

The Trustee argued that the choice of English law by the parties to the Leases should not apply as to the characterization of the transactions as either leases or secured transactions because the Trustee was a third-party representative of all creditors and “contractual choice of law provisions are not binding on third parties or otherwise capable of effecting the reclassification of security agreements into leases”.¹¹ The court considered a number of decisions by other bankruptcy courts that had to determine whether contractual choice of law clauses should prevail over the interests of a debtor’s creditors.¹² However, the court relied on In re Zukerkorn, 484 B.R. 182 (B.A.P. 9th Cir. 2012) and deemed the Trustee’s argument unpersuasive because in Zukerkorn, the court applied the Restatement’s choice of law rules despite the fact that the parties’ choice of law affected the debtor’s third-party creditors represented by a chapter 7 trustee.¹³  The court distinguished the other cases because two of them were decided under the choice of law rules of other states, and unlike the present case, the other involved an allegedly fraudulent agreement.¹⁴

Recharacterization Requirements under English Law

After addressing the choice of law issues, the court was then left to decide whether under English law the Leases should be recharacterized as security agreements. In its analysis of the English law approach to recharacterization, the court cited HFGL Ltd. & CNH Cap. Europe Ltd. v. Alex Lyon & Son Sales Managers & Auctioneers, Inc., 700 F. Supp. 2d 681 (D.N.J. 2010), which considered the distinction between English and U.S. law regarding ownership of leased property. The court provided a detailed analyses of the distinction under English law between a sale and a lease or a “hire purchase” (i.e., a lease with an end-of-term purchase option).¹⁵ Under a hire purchase agreement, the lessor retains ownership of the goods unless and until the lessee exercises its purchase option.¹⁶

Citing HFGL, the court notes that “[t]he laws of England and the United States ‘diverge on whether an owner retains title and ownership in property that is the subject of a hire purchase agreement’.”¹⁷ The court explained the differences between the English “formal” approach, and the “functional” approach under the UCC, when determining characterization of transactions documented as leases. The court cited to a well-recognized treatise regarding pertinent English law which provides that the established English law approach “sharply distinguishes the grant of security from the retention of title under conditional sale, hire-purchase and leasing agreements, on the basis that the buyer, hirer or lessee has merely a possessory interest, subject to which the seller, owner or lessor continues to enjoy absolute ownership by virtue of the agreement between the parties”.¹⁸ By contrast, recharacterization in the United States under the UCC is a fact-based inquiry analyzing, among other things, the economics of the transaction.¹⁹

In its conclusion, the court notes that the pleadings submitted by the Trustee included descriptions of the Leases containing an end-of-term purchase option, and that “[u]nder English law, a hire purchase agreement is viewed as a lease with an option to purchase at the end of the term.”²⁰ Based on those undisputed facts, the court concluded that “the transactions at issue were hire purchase agreements and it is undisputed that options to purchase the Four Aircraft were not exercised.”²¹ Accordingly, the court found that “the transactions are leases under English law and cannot be recharacterized as urged by the Trustee.”²²

Takeaways

Governing law provisions aren’t always enforceable. A court determining the enforceability of a governing law provision is likely to consider whether honoring that contractual choice of law agreed to between the contracting parties could have an adverse effect on third parties, especially in the context of a bankruptcy or other action involving the rights of creditors or similar claimants. Consider whether there might be essential issues that are unlikely to be decided by the contractually stipulated governing law, and whether there might be any applicable treaties, documentation or other transactional strategy to address the related risk. By way of example, parties could agree that matters involving conflicts of law should be decided by a law that might recognize the enforceability of the governing law choice.

Courts asked to consider most commercial law issues pertaining to installment sales, leases and other financings involving personalty are likely to reach the same conclusions irrespective as to whether the court applies U.S. commercial law (including the UCC) or English commercial law. However, there is an important distinction between how U.S. law and English law view title, and its implications to the respective rights and obligations of the purported owner and the counterparty, as well as to interested third parties.

Be aware of the risk that the governing law agreed to by parties to an asset financing might not be recognized by a court asked to consider issues that are essential to the parties achieving the benefits of their respective bargains. Accounting for this risk is especially important in cross-border transactions involving multiple legal regimes, as the laws may differ among them, including as to substantial issues at the heart of whether the parties will be able to achieve their bargained for benefits.