JOLCO-motion denied: aircraft finance termination payments not penalties

The English High Court has found that termination payments under Japanese Operating Lease with Call Option (JOLCO) structures did not amount to unenforceable penalties.

What is a JOLCO?

The characteristics of a JOLCO are that the aircraft is purchased by a special purchase vehicle with

• equity supplied by Japanese investors (perhaps 25%) who invest in the structure for tax reason, and 
• debt to finance the remainder (75%). 

The aircraft is then leased to an airline, which has one or more purchase options at agreed points. If the airline does not exercise the purchase option, it must return the aircraft at the end of the lease in the required return condition.

Each of the JOLCOs provided for VietJet to pay, in the event of termination following an Event of Default, sums corresponding to:

1. repayment of the outstanding balance of the loans which (in part) financed the aircraft acquisition; and
2. repayment of the equity contributions provided by the Japanese investors to fund the remaining purchase price and sums compensating them for the loss of the tax advantages.  

VietJet argued that these termination payments constituted penalties and were, therefore, unenforceable under English law.

Did the termination payments constitute penalties?

The court referred to the well-known test for a penalty clause in the Supreme Court decision in Makdessi.  This is whether the provision in question “imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”.  

The court held that the termination payments under the JOLCOs were not penal because (a) there were legitimate interests to protect, and (b) the provisions were not wholly disproportionate to those interests sought to be protected. In reaching this conclusion, the court considered the following:

1. VietJet is a sophisticated commercial actor with significant experience in aircraft financing, and was familiar with JOLCO arrangements.
2. The cost of equity finance under a JOLCO structure is much lower than any commercial financing that might be available to the airline because the tax advantages enjoyed by the Japanese investors are shared with the airline.
3. The entire viability of the JOLCO structures depended on prompt payment of rental payments by VietJet because of the way that the payments flowed up the structure.
4. The majority of the Japanese equity investors' return was not to be recovered from the payments made by VietJet, but from the tax advantages that the equity investors would have received had the transaction run to term.

As a result, FWA was entitled to termination payments totalling around USD165 million and possession of the aircraft.  This hints at how hard it is likely to be to show that a provision is an unenforceable penalty in certain contexts.

Judgment: FW Aviation v VietJet