When exotic aircraft finance collides with bankruptcy, aircraft finance wins, according to Bankruptcy Judge Sandra R. Klein of Los Angeles. More particularly, she ruled that sophisticated parties can elect to have English law govern a transaction and thereby bar the recharacterization of a lease as a disguised financing, even though none of the parties has any relationship to the U.K.

The case boiled down to this: The debtor was the lessee of aircraft. At the end of the term of the lease, the debtor could purchase each aircraft for a nominal amount. The trustee sued the lessor (that is, the erstwhile owner), contending that the lease should be recharacterized as a financing, because the lessee could become the owner at the end of the term of the lease by making a nominal payment.

Under U.S. law, the trustee could win, but not under English law.

Complex Aircraft Finance

The U.S.-based debtor operated private jet aircraft to ferry rich and famous people around the U.S. and the world. After the debtor filed a chapter 11 petition, a chapter 11 trustee was appointed and continued after conversion as the chapter 7 trustee.

Before bankruptcy, an aircraft lessor based in China obtained financing from the Canadian export development authority to purchase aircraft from a manufacturer in Canada.

The Chinese lessor’s subsidiary in Ireland indirectly leased the aircraft to the debtor’s subsidiary in Singapore. The Singapore subsidiary was a debtor along with its parent. The trusts acting as lessor and lessee were U.S.-based. The aircraft were operated by a California corporation.

The documents called for English law to apply to the transactions.

The trustee contended that California law should apply, not English law, and that the leases should be recharacterized as financings, because the debtors could acquire the aircraft for a nominal amount at the end of the term of the leases. The trustee argued that English law had no reasonable relationship to the parties or to the transaction.

Choice of Law

Judge Klein first addressed the choice of law, saying that the Ninth Circuit follows federal common law in bankruptcy cases. In turn, federal common law in the Ninth Circuit follows the Restatement (Second) of Conflict of Laws. Section 187 of the Restatement determines the enforceability of contractual choice-of-law provisions.

Section 187(1) says that the “law of the state chosen by the parties to govern their contractual rights and duties 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.”

Citing authority, Judge Klein interpreted Section 187(1) to mean that the 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.’”

Because there was no question about the ability of the parties to contract, Judge Klein held that English law must apply, “which was agreed to by the parties.”

The trustee nonetheless contended that the choice-of-law provision in the contracts did not apply to him because he was representing creditors to reclassify the leases. Judge Klein disagreed, citing the Ninth Circuit Bankruptcy Appellate Panel for holding that a trust settlor’s choice of law would be enforced against a trustee.

English Law Has No Recharacterization

Judge Klein then turned to English law, where the transaction is known as a hire purchase agreement.

English and U.S. law diverge here. In a hire purchase agreement, the lessor retains “absolute ownership” until the lessee exercises an option to purchase. Judge Klein said that English law “sharply distinguishes” the grant of a security interest from a hire purchase agreement. In contrast, she said, U.S. law employs a “functional approach” to recharacterization under the Uniform Commercial Code and conducts a “fact-intensive” inquiry to decide whether an agreement in the form of a lease should be considered a security interest.

Judge Klein held “that the transactions at issue were hire purchase agreements and it is undisputed that options to purchase the Four Aircraft were not exercised. Therefore, the transactions are leases under English law and cannot be recharacterized as urged by the Trustee.”

Lease recharacterization was the underpinning of the trustee’s claims, including preference and preservation of an unperfected security interest. Judge Klein dismissed the claims, granting the trustee leave to file an amended complaint in view of the “extreme liberality” required by Rule 7015.