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Partnering Perspectives | Summer 2018

Paved with good intentions: Why many companies’ flight operations are illegal and uninsuredBy Shawn Rafferty

Here’s a not-so-fun fact: a large percentage of US business aircraft flights violate federal law. Here’s another not-so-fun fact: most of those flights ultimately lack the protection of aviation insurance, even though the operator has purchased this coverage. Here’s a final not-so-fun fact: most of the companies conducting these flights are guided by prudent general business practices, and have no idea that they are regularly violating federal law.

So how is it that so many business flights, operated by sophisticated businesses and individuals, are flying in plain violation of applicable law? The bulk of these illegal flights arise from variations on a theme—the operator is unwittingly acting as a charter company.1 To understand how this happens, let’s look at both common business practices and the applicable legal frameworks.

1 Needless to say, there are other legal traps for the unwary wishing to operate aircraft in the course of their business. This article just touches on perhaps the most common mistake seen in this area.

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Summer 2018 | Partnering Perspectives

Competing legal frameworksMost businesses and individuals are aware of the substantial liability potential that comes with operating their own aircraft. And many of these same businesses and individuals address this potential liability by placing the aircraft into a special purpose entity (SPE), such as a limited liability company (LLC) or a corporation, to take advantage of the corporate veil these SPEs provide. To be cautious and responsible aircraft owners (and to protect their aircraft investment), these businesses insure the aircraft and its operations. The intended result is that the aircraft is safely tucked away in an SPE, its value is insured, and, if disaster strikes, the ultimate owner of the SPE is protected by the corporate veil. Under state law, an ownership structure like this is quite sensible.

For aircraft operations, though, this approach can easily run afoul of the Federal Aviation Regulations (FARs), which provide the legal framework for the ownership and operation of aircraft in the US and of US-registered aircraft anywhere in the world. The Federal Aviation Administration (FAA) uniformly lists its principal role as the regulation of civil aviation to promote safety.2 In keeping with that role, the FAA generates regulations controlling the operation of aircraft generally in Part 91 of the FARs. Part 91 provides the fundamental US regulatory framework for civil aviation, from the operation of an enthusiast’s Piper Cub, to a corporation using its Gulfstream G650, to an airline’s operation of an 853-seat A380.

Part 91 provides the basic and least restrictive ground rules for flights. For practical purposes, Part 91 provides nearly all of the operational rules for private flights. In the simplest case of a company buying a smaller aircraft to serve that company’s own flight needs (e.g., an electric power company using an aircraft to visit transmission facilities and power plants), Part 91 lays the regulatory groundwork for those operations.

The FAA imposes more stringent regulations upon commercial operations (technically “operations for compensation or hire”). These regulations exist to protect the flying public and to provide peace of mind that, when one hires an aircraft to fly from point A to point B, the flight will be safe. The logic behind this is sound. It’s one thing to fly your own Piper Cub from a local airport and crash into a cornfield (typically only doing damage to yourself and maybe some innocent stalks of corn). It’s quite another thing to hold yourself out as capable of taking people into the air for hire, with those passengers typically ignorant of the maintenance history of the aircraft and the qualifications of the pilot.

2 E.g., https://www.faa.gov/about/mission/activities/.

Part 135 houses the additional regulations applicable to commercial operations of aircraft of the size typically used in business operations. Suffice it to say that Part 135 regulations are more onerous than the basic Part 91 regulations they supplement. Part 135 adds equipment requirements, pilot qualification requirements, training requirements, maintenance requirements, and other requirements not invoked under Part 91, all for good reason. Under Part 135, an added layer of responsibility comes into play when a commercial operation holds itself out to the public to provide transportation services.

The crux of the problemWhen a business owner sets up an SPE to hold the aircraft, the business owner does so to isolate the liability associated with the aircraft. Under the basic principles of corporate law, the SPE is a distinct legal person apart from the business owner and the business itself. And this distinctness is what typically protects the owner and the business.

The problem, though, is that the SPE almost assuredly is not flying the aircraft on its own behalf. Instead, the SPE is flying the aircraft on behalf of the business owner’s primary business, which was the point of obtaining the aircraft in the first place. And that primary business (or the primary business owner) is almost assuredly underwriting the expense of the aircraft, and claiming deductions for doing so as a business expense (either on a combined return or individually). In short, the SPE is in the business of providing flight services to the primary business. In doing so, the SPE has become a charterer or, in FAA parlance, a “flight department company.” Therefore, the SPE’s flights on behalf of the primary business are subject to the more onerous Part 135 regulations.

The riskMost businesses that own and operate an aircraft under this SPE structure are only complying with Part 91 rules (and not Part 135 rules), and thus are flying illegally. The cost of doing this can be steep. To begin with, the FAA can impose a penalty of up to $25,000 per flight. Moreover, the pilots operating these flights can be subject to disciplinary action (including licensure action) if they are not qualified under Part 135.

It gets worse. When a party applies for aviation insurance, it typically makes various representations and warranties to the insurers. Those will usually include the insured confirming that it will use the aircraft for non-commercial operations (i.e., not on behalf of third parties) and that the insured will use the aircraft in a lawful manner. Since the FAA views the SPE operating the aircraft on behalf of the primary business as a commercial operation, the insurers arguably have a basis for denying coverage (casualty and liability) in the event of an accident or incident. And since the operations of the SPE do not comply with Part 135 requirements, they are illegal and provide the insurers with another basis for denying coverage.

Most businesses that own and operate an aircraft under this SPE structure are only complying with Part 91 rules (and not Part 135 rules), and thus are flying illegally. The cost of doing this can be steep.

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Partnering Perspectives | Summer 2018

EnforcementMany businesses using SPEs as company “flight departments” will object that they have operated this way for years without incident. After all, a significant number of businesses set up SPEs to hold their aircraft, and their operations are unimpeded by the FAA. This objection is understandable, given that these structures are common. It is critical to keep three points in mind, however, before dismissing concerns related to “flight department” violations. First, the FAA declining to aggressively enforce these violations in the past is no guarantee that they will continue that approach in the future. Second, while the FAA may not seem focused on ferreting out these types of violations, when there is an accident or incident, the FAA (and the National Transportation Safety Board) will typically shine a very bright light on the involved operator and its structure and operations. Third, insurers will often assert their contractual rights related to illegal operations to deny coverage. So even if the FAA does not aggressively enforce these violations, a business may find itself without coverage when it needs it most.

Who should care?Obviously, businesses using these SPE structures should be very attentive to this “flight department” issue. It is a trap for the unwary that can result in significant civil penalties and the loss of insurance coverage. It may also result in the breach of critical loan covenants.

Business aircraft financiers (lenders and lessors) should also be attentive to these matters, since the assets they are financing are imperiled by illegal operations and loss of coverage. While it is good to have loan covenants promising legal operation of a financed aircraft, that is cold comfort when the asset is substantially damaged and left uninsured.

Moreover, anyone with an interest in a business using such an SPE structure should be aware of the potential impact of “flight department” violations on the health of that business. For many businesses, an uninsured aviation loss (or large aggregated fines) could be a material adverse change threatening those businesses’ ability to operate as a going concern.

Is there a solution? This article offers an overview of one way that businesses frequently operate in unwitting violation of federal regulations, insurance warranties, and loan covenants. It’s important to recall, though, that there are many legitimate reasons that a business may want to place an aircraft in an SPE, including the isolation of liability. Skilled aviation counsel can help a business attain these fundamental goals without triggering repeated violations of the FARs, keeping the business’s flights legal and insured. Eversheds Sutherland is always happy to discuss these issues, and can offer cost-effective solutions to help ensure legal operations and proper risk management.

While it is good to have loan covenants promising legal operation of a financed aircraft, that is cold comfort when the asset is substantially damaged and left uninsured.

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Summer 2018 | Partnering Perspectives

Shawn Rafferty is a partner in the Atlanta office and has more than 20 years of experience working with domestic and international clients on all aspects of their equipment financing needs, including acquisitions and dispositions, restructuring, mortgage-financed transactions, pooled aircraft asset securitizations, sale and leaseback arrangements, and operating leases. From the beginning of Shawn’s practice,

he has been deeply involved in aviation, representing airlines, investors, lenders, and other parties involved in commercial and general aviation. In addition to his representation of aviation clients, Shawn regularly represents clients in many other industries, including transportation and logistics, banking and finance, energy, and telecommunications. Shawn can be reached at shawnrafferty@eversheds-sutherland.com.

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