Airport/Airline Agreements—Practices and Characteristics (2010)

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PART II HOW DO WE GET STARTED?

The general objective in negotiating Agreements is to develop a working relationship between the airport operator and the airlines as business partners, which ultimately will help each party achieve their respective goals and objectives. It is important to realize that compromise is part of this process for both parties; therefore, it is critical for each party to understand and prioritize its goals and objectives before entering into negotiations. A sample schedule of the negotiation process is presented on Exhibit 1. This schedule identifies typical steps, sequencing, meetings, and deliver- ables in connection with negotiations for the development of a new Agreement. The total time for this process can vary significantly from the timeline presented in Exhibit 1 depending on the com- plexity of issues involved in the negotiation and the amount of change sought in a new Agreement. In general, it is important to recognize that the negotiation process can take significant time and both parties need to begin preparations well before the current Agreement expires to minimize dis- ruption in rate setting, airport cash flow, and the management and development of the airport. As presented on the schedule in Exhibit 1, the negotiation process has been segregated into Phase 1 and Phase 2. Phase 1 of the process deals primarily with the negotiation of the busi- ness terms and provisions. Phase 2 is drafting the business deal into the actual Agreement doc- ument. This phase also includes the drafting of articles that will require legal review from both parties. Based on input received from airlines, airport operators, and general experience, split- ting the negotiation into these phases has been found to be more productive because it focuses the negotiation upfront on the fundamental business elements of the Agreement. It will also enable a better understanding of what has been agreed on when writing the business deal into the Agreement document. This chapter describes a typical negotiation process for both the airline and airport parties, identifies a sample timeline for negotiation activities, and presents some typical documenta- tion that can be used to support a negotiation. The schedule contained in Exhibit 1 can be used as a guide to assist the reader through this chapter. Please note that the process outlined in this chapter is intended to be a general guide for informational purposes only. More often than not, there will be specific issues or factors that may impact the process and require addi- tional steps (e.g., required airport board approvals, capital program reviews/approvals, legal reviews). 3.1 Typical Airline Negotiation Process Once it has been determined that the business arrangement at an airport needs to be modified— either through the pending expiration of the current Agreement or certain circumstances that warrant a change—the airport operator and the airline-airport affairs committee (AAAC) will generally communicate their intentions to enter into negotiations. In most cases, one of the AAAC 19 C H A P T E R 3 Negotiation Process and Schedule

Airline Process Airline/Airport Interaction Airport Processes M o n t h R e v i e w E x i s t i n g A g r e e m e n t A s s e s s P o l i t i c a l L a n d s c a p e & A i r l i n e P a r t i c i p a n t s E s t a b l i s h N e g o t i a t i n g C o m m i t t e e D e v e l o p A A A C G o a l s & O b j e c t i v e s N e g o t i a t i n g C o m m i t t e e B u s i n e s s D e a l R e v i e w R e v i e w A g r e e m e n t D o c u m e n t E x e c u t e A g r e e m e n t R e v i e w E x i s t i n g A g r e e m e n t E s t a b l i s h N e g o t i a t i n g C o m m i t t e e D e v e l o p A i r p o r t G o a l s & O b j e c t i v e s A s s e s s P a r t i c u l a r S t r e n g t h s a n d W e a k n e s s e s E v a l u a t e C I P & L e g a l / F i n a n c i a l / O p e r a t i o n a l A i r l i n e R a t e s & C h a r g e s A n a l y s e s D e v e l o p / R e v i s e T e r m S h e e t A i r p o r t B u s i n e s s D e a l R e v i e w D r a f t A g r e e m e n t D o c u m e n t R e v i e w A g r e e m e n t D o c u m e n t D i s t r i b u t e E x e c u t a b l e D o c u m e n t s 1 2 3 4 5 Kick-off Meeting - High Level Goal Discussion 6 7 8 9 10 11 12 Monthly (or more frequent if needed) Meetings on Business Deal Terms N E G O T I A T I O N P R O C E S S - P H A S E 1 13 Reach Agreement on Business Deal 14 15 16 17 Monthly (or more frequent if needed) Meetings on Agreement Document 18 Reach Agreement on Document 19 20 21 22 23 N E G O T I A T I O N P R O C E S S - P H A S E 2 24 Implement Agreement Note: This schedule identifies typical steps, sequencing, meetings, and deliverables in connection with negotiations for the development of a new Agreement. The total time for this process can vary significantly from the timeline presented depending on the complexity of issues involved in the negotiation and the amount of change sought in a new Agreement. Source: Ricondo & Associates, Inc., May 2009. Prepared by: Ricondo & Associates, Inc., May 2009. Exhibit 1. Typical negotiating process schedule.

members will be designated by that committee to take the lead in organizing the negotiation effort on behalf of the airlines. This individual is generally designated as the “Airline Chairperson” and this selection can be determined based on several factors including, but not limited to, airport market share, overall experience, current workload, or general familiarity with the airport oper- ator’s issues and staff. Once the Airline Chairperson has been designated, the negotiation process for the airline side generally commences. A critical portion of the negotiation effort occurs before the initial meet- ing with the airport operator because the airlines need to develop their overall position. Details on the typical airline negation process follow. Step 1: General Assessment The Airline Chairperson is generally responsible for undertaking much of the groundwork leading up to the negotiations. The initial step in this process can include an assessment of both the airport issues and conditions and the various factors within the airline group that are antic- ipated to impact the negotiations. Depending on the familiarity and experience of the Airline Chairperson, this step in the process may be very brief because the issues may be very apparent, or may take some time because additional research may be required. A review of the existing Agreement should also be undertaken early in the process. The Airline Chairperson will want to fully comprehend the various relevant political issues that may impact the upcoming negotiations. These issues may be on a local, regional, or even state level depending on the airport operator’s governance structure. Some examples of these issues can include the airline relationship with key airport operator decision makers, the influ- ence of the local government on the airport operator, the airport operator’s governing body approval process, consultant involvement, and local or regional issues regarding noise and capacity to name a few. After vetting the relevant airport factors, the Airline Chairperson will also assess the inter-airline issues that are anticipated to impact the upcoming negotiation. Understanding the general com- position of the airlines serving the airport and their general viewpoints on various key negotiat- ing issues will help the Airline Chairperson assess the relevant factors that will impact both the airport/airline negotiations and the inter-airline negotiations. The Airline Chairperson will need to develop an overall strategy to account for these issues for the negotiations. Certain examples of these include the following: • Market share composition of airlines (i.e., are there any dominate airlines, and if so, are they low-cost carriers [LCCs], legacy, cargo?) • Individual airline approval procedures for documents, and so forth • Airline alliances and or affiliations within the group • Individual personalities within the AAAC In a number of instances, the airline parties may, through the AAAC, request the services of an Airline Liaison Office (ALO) to assist with selected activities at a particular airport. The AAAC at a particular airport is primarily responsible for determining whether an ALO should be created and financed, and for establishing the nature and extent of the ALO’s responsibil- ities. An ALO provides a variety of services, including technical, financial, and properties sup- port at a specific airport on behalf of the participating parties at that airport. These ALOs may have a very narrow focus or a very broad focus, depending on the issues at the airport. In mak- ing a determination that an ALO is needed, the participating airlines must clearly define the proposed duties and responsibilities of the ALO. A key decision that must be made, in con- junction with the airport operator and appropriate legal counsel is whether the ALO will act in a consulting role, or whether the ALO will act as spokesperson for the participating airlines in the exercise of their duties. Negotiation Process and Schedule 21

Step 2: Establish a Negotiating Committee Once the Airline Chairperson has assessed the various airport and airline factors that are expected to impact the upcoming negotiation, a determination will need to be made on airline representa- tion for the negotiations. Given the effort and time required for a negotiation and the over- all number of signatory airlines at certain airports—not to mention the various workload issues for members of the AAAC at a given time, it may be more practical to designate a subset of the AAAC as the negotiation committee. In some cases, a smaller group can also effect a more efficient negoti- ation. However, it is important to note that all airlines have a right to be involved in the negotiations. If the AAAC agrees to create a negotiating committee, the following factors should be considered: • The committee reflects a fair and reasonable composition of the airlines operating at the airport. • Each member can commit to the required effort. • Each committee member can maintain credibility in representing the overall position and his/her own position. Step 3: Develop Airline Goals and Objectives One major challenge for airlines in any negotiation is the conflict between determining goals and objectives for their individual businesses as opposed to those that are carried forward for the overall AAAC as part of the negotiations. To resolve this conflict, it is especially important for the Airline Chairperson and members of the negotiating committee (if applicable) to allow each airline to voice its goals and objectives. However, it is generally assumed that the negotiating committee will need to establish defined overall goals and objectives to enable a successful nego- tiation. Therefore, compromise and agreement amongst the AAAC in developing its goals and objectives are important steps in the process. Goals and objectives can generally start as higher-level initiatives and then eventually materi- alize into more specific statements regarding what is to be accomplished. These goals and objec- tives can then be prioritized to reflect the overall negotiating objectives of the AAAC. If a separate negotiating committee has been established, the goals and objectives need to reflect those agreed upon by the broader AAAC. At this point in the process, the airlines have generally completed their preparation for the nego- tiations. The airport operator normally undertakes its general preparation simultaneously (see Sec- tion 3.2 for more information on the airport process). Next, a kick-off meeting is scheduled to discuss each party’s high-level goals, discuss the development of a term sheet, and establish a meet- ing schedule for the next several months. An example of topics included in term sheets used to assist in the negotiations is included in Exhibit 2. The number and frequency of negotiating meetings will depend on the overall complexity of the business objectives to be negotiated and how far apart the parties may be on them. It is suggested that meetings be scheduled at least on a monthly basis to keep the negotiations moving. It may be difficult to meet more frequently than monthly due to committee and airport operator availability, internal group review and feedback time, and other scheduling issues; however, in some cases, it may be required due to time constraints. Step 4: Negotiating Committee Review of Business Deal It is suggested that an agreed upon term sheet be used throughout the negotiations of the busi- ness deal to track what terms have been agreed upon and which warrant further discussion. After each meeting with the airport operator, the negotiating committee should meet inter- nally and communicate to the AAAC as needed on the status of the negotiations. The term sheet should be updated and discussed and any changes in strategy or negotiating positions should be resolved prior to the next meeting with the airport operator. It may take several meetings with the internal airline negotiating committee and with the airport to reach agreement on the busi- ness deal. Once agreement has been reached, the negotiations enter into Phase 2. 22 Airport/Airline Agreements—Practices and Characteristics

Source: Ricondo & Associates, Inc., May 2009. Prepared by: Ricondo & Associates, Inc., May 2009. Step 5: Review Agreement Document As with the business deal negotiations, the review of the Agreement document may take sev- eral iterations before both parties come to agreement. Therefore, a meeting schedule, both inter- nally with the airline negotiating committee and with the airport operator, should be agreed upon in advance. The review of the Agreement document may also involve coordination with other departments within the airline (e.g., legal and finance); therefore, it is important to allow time for these groups to conduct their required due diligence. Negotiation Process and Schedule 23 Exhibit 2. Items commonly included in a term sheet. Hint: In some instances, it may be more efficient from a time perspective to provide the airline legal departments with “non-business deal” articles of the Agreement during the business deal negotiations (i.e., articles dealing with damage and destruction, insurance, indemnification, general government provisions). These articles do not generally impact the fundamental business deal negotiations, and preparing them now could potentially save some required review time by airline legal groups at the end of the process.

At this point in the process, the airport operator is responsible for providing the first draft of the Agreement document and controlling and tracking changes after each meeting. It is important for the airlines to review the first draft of the Agreement to confirm that it properly reflects the busi- ness deal that was agreed upon during Phase 1 of the negotiations. The Airline Chairperson can be the point person for all airline comments to the airport operator on the draft Agreement. Time needs to be allotted for the airport operator to document the changes to the draft Agreement and to distribute the document to the airlines. Also, the individual airlines need time to review and pro- vide comments to the Airline Chairperson in advance of the next meeting. This process takes place until agreement on the draft document is reached by both parties. Step 6: Execute Agreement Once the airlines and airport operator agree on the draft document, the airport operator distrib- utes a final executable version of the Agreement to each airline expecting to sign. It is important to understand that each airline has to undergo its own internal approval before being able to sign an Agreement. Approval process time may vary. For example, one airline may be able to execute an Agreement within a week’s time while other airlines may take several months for the approval process. This time needs to be understood by both airlines and airport operators and considered part of the overall time requirement anticipated for the completion of the negotiation process. 3.2 Typical Airport Operator Negotiation Process Step 1: Review Existing Agreement and Develop Airport Operator Goals and Objectives Parties on the airport operator side need to identify their specific financial and operational goals and objectives for the new Agreement. As a starting point, the airport operator parties should review their existing Agreement to identify and address any areas of concern, including the level of risk the airport operator parties are willing to assume. In general, the following types of information should be considered and evaluated (see Section 4.1 for further details): • The airport’s future capital development needs • The level of control the airport operator seeks to maintain over its capital development program • The level and type of control the airport operator needs over gates and other facilities • The financial and operational commitment it is seeking from its tenant airlines • How much discretionary cash flow is required to meet airport financial, operational, and developmental requirements Once defined, the goals and objectives should be categorized into needs versus wants (needs are considered to be deal breakers from the airport operator’s standpoint; wants are typically prioritized and assessed). The airport operator may also want to consider the appropriate personnel for the negotiating committee. This may be the airport director, finance director, business development director, and other staff and or consultants required. This is the key group that will be involved through- out the process from the airport operator side. Step 2: Assess Airport Strengths and Weaknesses Each airport has fundamental economic and market characteristics that make it unique. The key to a successful negotiation from both the airport operator and the airline perspective is understanding these economic drivers and unique airport factors. Generally, handpicking cer- tain business provisions or approaches from one airport may not necessarily work at another airport—so be cautious of this. 24 Airport/Airline Agreements—Practices and Characteristics

Some examples of key economic drivers and unique airport factors include the following. Please note that this is not an exhaustive list. There may be several more factors depending on the airport or market (see Section 4.2 for further details): • Market orientation (e.g., origin, destination, major connecting hub) • Overall passenger volumes and trends (e.g., hub size, rapid growth market) • Air service composition (e.g., major low-cost carrier presence, cargo presence) • General capital/debt position (i.e., has the airport just completed a major capital expansion or is it about to undertake one?) • Local airport competition • Overall levels of non-airline revenue (e.g., parking revenue, terminal concessions) • Type of airport governance (e.g., state, city/county, authority) Understanding these general factors will assist the airport operator with determining goals and objectives that may best capitalize on its strengths and mitigate its weaknesses. It may also pro- vide the airport operator with a general understanding of its leverage position with the airlines. Step 3: Incorporate Capital Development Needs and Develop Priorities It is important to consider planned airport capital development needs for incorporation into the proposed business deal and airline rates and charges scenarios. The size and scope of future capital development needs can affect an airport operator’s leverage in negotiating the new Agree- ment. All available capital funding sources should be examined in this step (i.e., Federal Avia- tion Administration [FAA] Airport Improvement Program grants, Passenger Facility Charges [PFCs], Customer Facility Charges [CFCs], available state sources) to assess the financial impacts on both the airport operator and the airlines. Step 4: Prepare Rates and Charges Analyses and Business Proposal This step can require significant effort because it is where the airport operator attempts to achieve its goals and objectives through quantified airline rates and charges. This process could include the development of alternative approaches to revenue enhancement, optimum treat- ment of debt service coverage, and a reexamination of funding sources for capital improve- ments (see Section 4.4 for additional information and suggested approaches to the development of airline rates and charges analyses). Once the airport operator determines a preferred approach for its airline rates and charges methodology and has a general order of magnitude understanding of airline impacts, it is prepared for the kick-off meeting with the airlines as described in Section 3.1, Step 3. High-level goals, a schedule of meetings, and the development of a term sheet are generally discussed at this meeting. The airline rates and charges analyses will most likely continue throughout negotiations with the airlines as the business deal evolves. The airlines may request certain analyses that measure financial impacts to the airlines as a whole and on an individual basis. Step 5: Airport Operator Review of Business Deal It is suggested that an agreed upon term sheet be used throughout the negotiations of the busi- ness deal to track what terms have been agreed upon and which warrant further discussion. Refer to Exhibit 2 for commonly included items on term sheets for airline/airport operator negotiations. After each meeting with the airlines, the airport operator should meet internally as needed on the status of the negotiations. The term sheet should be updated and discussed and any changes in strategy or negotiating positions should be resolved before the next meeting with the airlines. It may take several meetings internally and with the airlines to reach agreement on the business deal. Once agreement has been reached, the negotiations enter Phase 2. Negotiation Process and Schedule 25

As with the business deal negotiations, the review of the Agreement document may take sev- eral iterations before both parties come to agreement. Therefore, a meeting schedule, both inter- nally with the airline negotiating committee and with the airport operator, should be agreed upon in advance. The review of the Agreement document also may involve coordination with various airport departments (e.g., legal counsel); therefore, it is important to allow time for these groups to conduct their required due diligence. Step 7: Distribute Executable Agreement Once the airlines and airport operator agree on the draft document, the airport operator distrib- utes a final executable version of the Agreement to each airline expecting to sign. It is important to understand that each airline has to undergo its own internal approval process before being able to sign an Agreement. Again, approval process time may vary. For example, one airline may be able to execute an Agreement within a week’s time while other airlines may take several months for the approval process. This time needs to be understood by both the airlines and the airport operators and considered part of the overall time requirement. Step 6: Prepare and Review Draft Agreement After the business deal has been agreed upon, the airport operator will be responsible for preparing a draft Agreement to incorporate the agreed upon business deal. An example table of contents for a typical agreement can be found in Appendix B. 26 Airport/Airline Agreements—Practices and Characteristics Hint: It may be beneficial to start drafting a “boilerplate” Agreement during the business deal negotiations to save time in the schedule for document prepara- tion. Also, in some instances, it may be more efficient from a time perspective to provide the airline legal departments with “non-business deal” articles of the Agreement during the business deal negotiations (i.e., articles dealing with dam- age and destruction, insurance, indemnification, general government provisions). These articles do not generally impact the fundamental business deal negotia- tions and preparing them now could potentially save some required review time by airline legal groups at the end of the process.

Chapter 3 presented the overall process of negotiations; this chapter addresses the preparation, analyses, and development of preferred strategies to assist in the formulation of the business arrange- ment for the negotiations. This chapter will describe the importance of developing specific goals and objectives; the importance of proper accounting and categorization of airport finances; recognition of the constraints and parameters that a business arrangement must reside within; and develop- ment of the specific rates and charges formulas that quantify the business arrangement being con- sidered and negotiated. Included in this chapter is the information to assist the airlines and airport operators in their analyses and evaluation of the business arrangement being negotiated. 4.1 Goals and Objectives Before initiating any negotiations for a new Agreement, each party must understand and attempt to quantify what it is trying to achieve. This is accomplished through the development of goals and objectives and the prioritization of such. This section will describe this process from both the airline and airport perspective. 4.1.1 Specific Considerations for Airlines Determining airline goals and objectives for a business arrangement negotiation can be a com- plex process because each individual company has its own internal process and goals that need to be incorporated and negotiated among the AAAC to arrive at consolidated objectives by the com- mittee. Current economic conditions and unique market conditions of the airport where the nego- tiations are taking place also need to be considered. In other words, certain objectives one airline may have recently negotiated at another airport may or may not be those sought at that particular airport. Many factors influence the determination of airline negotiating goals and objectives at a particular airport such as airline market share, airport capacity constraints, and airport costs. Each airline company has its own process for approaching an upcoming Agreement business negotiation, generally through its airport properties or corporate real estate departments. In deter- mining its specific goals and objectives, an airline will determine how that specific airport fits into its overall corporate strategy. Some examples of what airlines do internally are as follows: • Take an inventory of the amount and type of space the airline is currently leasing at the airport. • Coordinate with other internal stakeholder departments such as aircraft scheduling, flight oper- ations, maintenance, engineering, and cargo to assist in developing future space expectations at a particular airport. • Determine the airline’s level of control over its current space. For example, does the current situation provide for an ability to expand at the airport in the future? 27 C H A P T E R 4 Key Items to Identify Prior to a Negotiation

• What is the age of the Agreement that is expiring or being changed? If the airport is coming off an old Agreement, there may be significant changes needed to update the situation. • Analyze the costs to the airline. Are the costs prohibitive to the airline’s future plans and how are the costs allocated among the airline users? • Evaluate the airport’s capital program. Depending on the size and scope, this can be a major driver of a future business deal. How does the capital program impact the airline and does it fit in with the airline’s overall plans for that airport? • The airline may also coordinate with its appropriate legal department early on to initiate an assessment of any specific areas of risk with regard to insurance, indemnification, and envi- ronmental provisions. • Review historical trends in O&M expenses at the airport. As discussed in Chapter 3, coordinating the efforts of the airlines (or AAAC) in Agreement negotiations is generally the responsibility of the Airline Chairperson. This person also takes on a significant role in developing the overall consensus goals and objectives of the AAAC for a nego- tiation. Some of the negotiating objectives for the airlines may be easier to arrive at a consensus, for example: • Lowering airline rates and charges levels • Ensuring costs are fairly and appropriately allocated among the users • Flexibility in using or leasing needed terminal facilities • Increasing control over certain capital development projects • Minimizing airline financial risk for vacant terminal space However, there are also several issues that may be more difficult to gain agreement on among all the airlines in the AAAC. Many of these types of issues can be related to specific applications of the objectives described in the preceding list, such as joint use formulas, treatment of affili- ated airlines, thresholds for signatory status, and allocation of costs. Many of these issues are described in more detail in Part 3 of this Manual. Airline Chairperson has the responsibility to solicit input from all the members of the AAAC and to look at the benefits and costs of the issues as a whole. Compromise is to be expected, and the airlines can generally work through the issues; however, in certain cases where consensus can- not be reached, the Airline Chairperson will generally notify the airport operator that agreement was not obtained. In these cases, it may require the airport operator to make a policy decision to assist in achieving resolution. 4.1.2 Specific Considerations for Airport Operators One of the most important aspects of any negotiation of an Agreement is the determination of the airport operator’s financial, operational, and developmental goals and objectives. After identifying the list of objectives, the airport operator should prioritize that list. An airport oper- ator should focus on its particular objectives and the priorities of each, with due consideration given to its particular strengths and weaknesses, otherwise the following could occur: • The airport operator may not know how well it did when the negotiations are completed, because it did not adequately quantify what it was trying to achieve before the negotiations began. • The airport operator may find itself negotiating for provisions that are either conflicting or unnec- essary, or worse, seeking a business arrangement that might be virtually impossible to obtain. As part of this process, it is also extremely important that an airport operator not overly concern itself with provisions in Agreements at other airports. While it is recognized that using language from other airport Agreements that has been tested, tried, and revised for certain provisions may save an airport operator unnecessary time and frustration, a particular provision should never be used in an Agreement solely because it works for another airport operator. Each airport operator must negotiate for provisions that fit its particular circumstances. 28 Airport/Airline Agreements—Practices and Characteristics

For an airport operator, arriving at a list of negotiating objectives is an iterative process. The airport operator should first list its initial objectives, and then consider the issues and negotiat- ing strengths it has to develop an acceptable strategy for the negotiation. For example, airport operator’s objectives could include the following: • A shorter term Agreement • Reduction in the amount of exclusive space leased to the airlines • Elimination of the current subleasing trend • Greater flexibility and control over planned capital development decisions • Ability to relocate airlines to better provide for new entrant or expanding airlines • Increased discretionary funds for capital development • Reasonable levels of airline fees and charges • A more entrepreneurial business approach (especially if the existing Agreement is residual and the airport operator desires a more compensatory or hybrid approach) Upon the initial development of its proposed business relationship with the airlines, it is important for an airport operator to focus on and develop its objectives for a negotiation, along with preparing the appropriate rates and charges documentation. In other words, the airport operator has to determine its absolute needs; what it wants beyond that; how reasonable the overall package is; and how much negotiating leverage it has. These elements are discussed in the following paragraphs. Needs. This is the most critical area of an airport operator’s objectives. Needs represent the bottom-line requirements of an airport operator’s preferred business arrangement with the airlines and are relatively uncontrollable from the airport operator’s perspective. The pri- mary needs become the airport operator’s most important objectives. These could be consid- ered deal breakers for the airport operator. Two examples of critical needs could be (1) an airport operator planning to issue revenue bonds for its capital program must obtain a busi- ness arrangement that will provide reasonable security for the additional bonds and outstand- ing bonds in regards to the ability to meet its annual rate covenant and (2) if an airport oper- ator plans to undertake a major capital program and airline support is sought for that, achieving a business arrangement that facilitates undertaking the capital program becomes an important “need.” There are many considerations that the airport operator will need to identify and evaluate as it develops its preferred business arrangement with the airlines. Some examples of these are as follows: • Level of financial risk • Reward and control tradeoffs • Control over operating and development decisions • Level of discretionary income • Type of landlord-tenant relationship (preferential or exclusive, access clauses, subletting and assignment rights) For an airport operator, determining its needs may appear straightforward but, typically, a lot of tough issues must be considered in this process. Most of these issues relate to sorting out a true requirement from a want that the airlines could view as unnecessary. The following are examples: • An airport operator wants to develop additional space in the terminal should a new airline decide to serve that airport in the future. While the airport operator might consider this a critical need, any unreasonable amount of space should be considered a want. • An airport operator may plan an ambitious and expensive capital program that the commu- nity feels is important. However, if the economics do not make sense for that particular airport, the potential enhancements may need to be moved to the want category. Key Items to Identify Prior to a Negotiation 29

Wants. Wants refer to all of the other provisions that an airport operator might seek in negotiating a new Agreement. There is nothing wrong with identifying as many wants as the air- port operator believes is appropriate. However, these wants should be reasonable, and the air- port operator should have sufficient leverage to obtain them. Wants are more discretionary objectives and relate to the airport’s operating and developmental goals—the type of business arrangement the airport operator wants with the airlines. It is also important to note here that when identifying its objectives, an airport operator must take into consideration that an absolute necessity for it could be a discretionary objective at another airport, and vice versa. Of primary importance is the ability to identify what an airport operator absolutely needs and what it would like to have. It must also be able to recognize the difference between the two. Also, there are reasonableness tests that need to be applied during the process of identifying objectives. For example, an airport operator might want the airlines to assume all financial risk in a new Agreement, while at the same time minimizing airline participation in capital and oper- ating decisions. Airlines will not generally view this combination as reasonable. 4.2 Identifying Particular Negotiation Strengths and Weaknesses Before an airport operator can finalize its objectives or arrive at an overall negotiation strategy, it has to carefully examine all the factors that can impact the objectives identified, beginning with determining the airport operator’s negotiating strengths and weaknesses (i.e., leverage). Essen- tially, leverage is the net total of an airport operator’s negotiating strengths and weaknesses at any point in time. There are a number of internal (airport-centric) and external factors that help shape an airport operator’s final objectives and negotiating package. These factors play a major role in identifying the amount of leverage an airport operator has during a negotiation. Airport or internal factors include all the characteristics of an airport and its current situation that contribute to shaping what the airport operator is trying to accomplish and the degree of negotiating leverage that the airport operator has. The following are examples: • What is the strength of the airport’s underlying market? • Does the airport have a strong origin and destination (O&D) base that will support multiple airlines? • How robust is the airport operator’s non-airline revenue? • What is the airport operator’s current debt position? • Is there any other regional airport competition? • Is the airport dominated by either a legacy airline or a low-cost carrier? • Is the airport a connecting hub for a legacy airline or a focus city for a low-cost carrier? • What are the current airport passenger volumes and how are they trending? • Is the airport operator trying to undertake a major capital program at the same time it is nego- tiating a new Agreement? • How does the airport operator’s board or governing body respond to risk and reward tradeoffs? • What is the importance to the airport of its operating versus developmental goals, and does the airport’s board or governing body agree? There are certainly many other particular circumstances that impact a particular airport opera- tor. It is important for an airport operator to clearly recognize those factors that will impact nego- tiations, so that priorities and tradeoffs can be identified before initiating negotiations. External factors potentially impacting an airport operator’s objectives include the airline industry, financial community, and federal legislation, policies, and other legal factors. The state of the airline industry will certainly have an impact on an airport operator’s negotiation. When an airport operator begins negotiating its Agreement with the airlines, will it be during a time of 30 Airport/Airline Agreements—Practices and Characteristics

Source: Ricondo & Associates, Inc., May 2009. Prepared by: Ricondo & Associates, Inc., May 2009. Varying Importance of Issues • Capital Control • Facility Control • Discretionary Revenue • Risk/Reward Balance • Security for Payment • Rates & Charges • Signatory Airline Rights • Term Varying Degrees of Drivers • Market Orientation • Passenger Volumes/Trends • Air Service Composition • CIP • Debt Position • Local Airport Competition • Non-Airline Revenues • Type of Governance Airport-specific Mix of Issues & Drivers growth in the industry, or will the airlines be dealing with more pressing issues and be unable to focus on the particular airport’s negotiation? For the financial community, issues relate to the security of an airport operator’s revenue bond debt. The business arrangement negotiated should consider the industry views of the investment community. Even if currently an airport operator does not have outstanding revenue bond debt, it may sometime during the term of the new Agreement. Generally speaking, the financial com- munity is not focused necessarily on any particular type of business arrangement, but it must make sense for that particular airport, and provide adequate security for the revenue bond debt at that airport (Chapter 6 discusses investment community concerns in more detail). No matter how reasonable an airport operator’s objectives are, leverage is absolutely critical to the outcome of a negotiation. Leverage also shifts over time, and the airport operator must fully understand the amount of current leverage it has when entering a negotiation. To summarize, anyone can write an Agreement that the other party will not sign. The airport operator must identify its initial wants and needs, then consider its negotiating strengths and weaknesses, then finally arrive at a “package” of objectives that represents a reasonable compro- mise between what it wants and needs and its ability to achieve such a package. Exhibit 3 pres- ents this process in a graphical format. As illustrated, the varying importance of goals and objec- tives versus the differing degree of unique drivers for an airport, yield a specific mix that is unique to each airline and airport operator business negotiations. 4.3 Cost Centers and Allocations of Expenses and Revenues As the development of rates and charges formulas are critical to the quantification of the busi- ness arrangement negotiated between the airport operator and airlines, it is also critical that the air- port’s accounting and cost center structure support that process. The airport’s cost center account- Key Items to Identify Prior to a Negotiation 31 Exhibit 3. Airport operator goals and objectives versus strengths and weaknesses.

ing structure should maintain and categorize all of the airport’s revenues, expenses (operating and non-operating), debt service, fund deposit requirements, and any other financial obligations into a formal group of cost centers for accounting and rate-making purposes. This structure also assists the airport operator in developing other tenant and user rates and charges, as well as understand- ing the areas of the airport that are financially self-supporting and those that are not, so the airport operator can focus on improving financial performance in those needed areas. Segregating key areas of the airport will also help ensure that costs that should be the obligation of one particular tenant or user are not being subsidized by some other tenant or user. There are essentially two types of cost centers. One type is direct, revenue-producing cost cen- ters in which the airport’s physical and key functional areas will be organized into a group of revenue-producing cost centers that make up the airport boundaries. The other type is indirect or functional. These represent the various functions provided at the airport (e.g., operations, airfield maintenance, terminal maintenance, ARFF, and administration) that are either directly charged or assigned to specific revenue-producing cost centers or are allocated based on percentages. 4.3.1 Revenue-Producing Cost Centers Typical revenue-producing cost centers could include the airfield, terminal, parking, cargo, hangars, and other key areas of the airport. If the airport operator is responsible for an airport system, the other airports in the system could become separate cost centers within the overall cost center structure. Depending on the size of the airport, or the size of any particular revenue- producing area, variations to the cost center structure are certainly acceptable. The airport oper- ator should, however, strike a balance between developing enough cost centers to support its financial and accounting needs without developing so many cost centers that they create a cum- bersome administrative burden. Some airports may group all ground transportation functions (e.g., auto parking, rental cars, taxi, limousine) including all airport roadways, into a ground transportation cost center. If cargo or hangar are not material activities at an airport, a consolidated cost center could be developed for these aviation-related functions. Flight kitchens, general aviation, or other aviation-related activities could also be included in this “aviation” cost center. The airfield cost center could include general aviation, fixed base operator facilities, and fueling facilities, depending on the airport operator’s preference and the materiality of the activities in the airfield. However, some airport operators also include these particular activities in the aviation cost center and leave the airfield for the movement of aircraft through the taxiway and runway system at the airport. Another sub-area of the airfield consists of both the terminal aircraft aprons and the cargo aircraft aprons. It is preferred that these areas be isolated and segregated from the airfield, primarily for rate-making purposes, to ensure that the costs of operating, maintaining, and devel- oping those particular facilities are borne by the specific tenants and users of those facilities. There are also a number of “non-aviation-related” activities at an airport. These can include commercial buildings, hotels, various ground leases, and any other activities that are not directly related to aviation purposes. Here again, whether each non-aviation activity is a separate cost center or whether activities are grouped together into one cost center is primarily a function of materiality, airport operator preference, and the ability of the accounting or cost center system to segregate and isolate particular functions and activities. Revenues of the airport, or airport system, should be “assigned” to their appropriate cost cen- ter for financial reporting purposes. Revenues are assigned and remain in that assigned cost cen- ter each year. Many revenue sources will be self-explanatory, but there are a few that would need to be assigned to multiple cost centers. For example, while rental car concession revenue would be in a ground transportation or separate rental car cost center, any counter or office areas leased 32 Airport/Airline Agreements—Practices and Characteristics

in the terminal would be assigned to the terminal cost center, and their support facilities may be assigned to a non-aviation cost center. In summary, the identification and formalization of an airport’s revenue-producing cost centers must provide for the transparent assignments and allocations of all accounting transactions in the airport’s (or airport system’s) revenues, expenses, debt service, fund deposit requirements, and any other financial obligations. There is certainly flexibility and freedom to identify selected cost centers at an airport, and to create separate cost centers depending on the level of activity at an airport, along with the need to isolate the financial performance of that activity. However, whatever structure is developed, the accounting must be transparent and consistently applied by the airport operator. 4.3.2 Functional Area Cost Centers These functional areas or indirect cost centers are primarily for aggregating the costs of opera- tion and maintenance expenses at an airport. Similar to airport revenues, functional cost centers can consist of a number of different functions that are represented in the expense stream. Typical functional areas could include operations, building maintenance, airfield maintenance, engineer- ing, development, police, and ARFF. Other functions that typically fall under the category of “administrative” include executive, legal, marketing, public relations, finance, accounting, prop- erties, administrative services, and human resources. For many fees and charges developed from the rates and charges formulas which are cost-based rates and charges, it is very important that the process and formulas for assigning and/or allocating expenses to revenue-producing cost centers be transparent and reflect where these various functions are actually spending their time and effort. It is preferred that the airport operator’s accounting sys- tem have the capability to directly assign expenses to cost centers, thereby minimizing those expenses that must be allocated based on percentages. While a job cost system, labor distribution system, and other software can contribute significantly to the accuracy of assignments and allocations, many air- port operators are unable to absorb the financial burden to implement such systems. An alternative is for the airport operator to perform a review of its functions and determine the appropriate relationship to assign or allocate expenses throughout the revenue-producing cost cen- ters. In some Agreements, some of these percentages may be “fixed” during the term of the Agree- ment. Other Agreements provide for the airport operator to monitor those relationships, evaluate them every 2 to 3 years, and adjust them as necessary when developing airline fees and charges. The goal is to minimize the subjectivity of the assignments and allocations through having a structured approach and process in place for both budget development and end-of-year settlement. Exhibit 4 presents a typical cost center flow chart for illustrative purposes. 4.4 Capital Program Requirements Identifying, planning, quantifying, and implementing a CIP represents another key aspect of a negotiation for an airport operator. In many cases, an airport operator is planning to under- take a CIP at the same time it is negotiating a new business arrangement with its airlines. In most cases, the financial impacts associated with the implementation of a CIP can represent the great- est increase in airline fees and charges at an airport. These impacts will receive the greatest scrutiny by the airlines in a negotiation. Therefore, it is critical that the airport operator plan and prioritize the CIP to balance the need for undertaking specific capital projects with minimizing the financial impacts to the airlines. The CIP process can be a very long and drawn-out procedure with several challenges for an airport operator. The process is also one that needs to adapt to an ever-changing environment. Key Items to Identify Prior to a Negotiation 33

Airfield/Apron Exp/Rev. are basis of landing and apron fees Airfield/Apron Terminal Exp/Rev. are basis for terminal rentals and charges Terminal Exp.Rev. assigned to other cost centers are basis of fees and charges for other tenants/users Other Airfield/Apron Terminal Air Cargo Non-Aviation Aviation Ground Transportation General Aviation Revenues, Expenses, and Reserves Assigned to Cost Centers Allocation of Overhead Expenses to Direct Cost Centers Rate Centers and Calculation of Tenant Fees Required Reserves Debt Service O&M Expenses Revenues Indirect (Non-Revenue Overhead Cost Centers) Direct (Revenue Producing) Air Cargo Aviation Terminal Airfield/Apron Non-Aviation Ground Transportation General Aviation Maintenance Development Operations Administration ARFF Police Source: Ricondo & Associates, Inc., May 2009. Prepared by: Ricondo & Associates, Inc., May 2009. In other words, the development of “permanent” facilities to accommodate dynamic aviation needs is a major challenge. One aspect in particular that can become an issue between airlines and airport operators in planning for facilities is the timeframe. Because airport operators generally take a broader perspective of supporting the overall aviation needs of the overall community and region, their planning horizon can be very long term in nature. A long-term planning process is also a requirement per the FAA’s airport master planning process. On the other hand, airlines may not necessarily share a similar long-term planning horizon at some airports because they need to be well positioned for flexibility to compete in a dynamic industry. Given these differing viewpoints, an airport’s CIP can become a major issue surrounding a business negotiation between airlines and airport operators. Airports are encouraged to make sure that any proposed capital development is consistent with the strategies for the airport, represents projects/programs that have been reviewed with key stakeholders (e.g., airlines), and is financially feasible. This becomes even more critical when an airport is negotiating an Agreement with its airlines at the same time as undertaking capital development. The airport operator needs to make sure that the capital development is worth potentially decreasing its leverage, thereby forcing it to accept a less than ideal business arrange- 34 Airport/Airline Agreements—Practices and Characteristics Exhibit 4. Typical cost center flow chart.

Source: Ricondo & Associates, Inc., May 2009. Prepared by: Ricondo & Associates, Inc., May 2009. ment with the airlines in exchange for being able to undertake the capital development. Appen- dix C provides greater detail about the capital development process and its management. 4.5 Airline Rates and Charges Analysis Preparation of the rates and charges analysis will be one of the more important documents developed for a negotiation. This analysis quantifies the airport operator’s primary goals and objectives through the proposed rates and charges formulas identified in the analysis. This doc- ument also incorporates all of the airport’s financial and operational assumptions that are included in the analysis. It is important that the information presented in this analysis be pre- sented in a clear and concise manner to assist the airline parties in understanding the rationale supporting the projections. It is also important that projections be realistic and supportable. Exhibit 5 presents the flow of information to be incorporated in the rates and charges analysis and is discussed in the following paragraphs. Airport Aviation Activity contains the airport the projections of passenger enplanements and aircraft landed weight annually during the term proposed in the new Agreement. Knowing passenger enplanements will assist in the projections of those non-airline revenue sources that are driven, to a large degree, by passenger enplanement activity at the airport. It will also be used in calculating the joint use formula terminal revenues (by airline), and in measuring the pro- jected cost per enplanement. The landed weight will be primarily used in calculating the landing Key Items to Identify Prior to a Negotiation 35 Exhibit 5. Typical flow chart for rates and charges financial model.

fee rate. Terminal Space identifies the breakdown of terminal space by functional area (e.g., ticket counter, holdroom, baggage claim, etc.) and category (e.g., rentable, public, administra- tion, etc.). Depending on the proposed terminal rental rate formula, a category of terminal space will also be used in the calculation of the terminal rental rate proposed in the business deal. The Capital Improvement Program and Capital Costs identify those projects expected to be undertaken during the term of the proposed agreement. The CIP will list all of the projects antic- ipated to be undertaken by the airport operator by cost center. It will also contain the assump- tions of funding sources to be applied toward those projects. Capital Costs contains the annual impacts (e.g., debt service, amortization, PFCs applied to debt service) associated with the CIP that will be included in the business deal, whether directly in a rate base formula or in another airport cost center. The Capital Costs will also be included in the overall cash flow of the airport. Operating Expenses and Non-airline Revenue will include projections for the proposed term of the Agreement. Where applicable, projections in these two areas should be developed for spe- cific line items and distributed or allocated to the appropriate airport cost center. It is important to understand the distribution of responsibilities between the airport operator and the airlines when developing operating expense projections. A typical matrix that can be used as an exhibit to the Agreement describing operating expense responsibilities is illustrated in Exhibit 6. Airline Rates and Charges are then calculated from the formulas established in the proposed business deal. This includes the specific rate structure for both the landing fee and the terminal rental rate, as well as other rates that may be calculated as part of the business deal (e.g., apron fee). From these rates, the total amount of airline costs will be calculated, and the resultant Cost per Enplaned Passenger will be calculated. Airport Cash Flow includes the projections of all airline and non-airline revenues, as well as operating expenses, debt service, and any other obligations of the airport. In this same schedule, is the Debt Service Coverage ratio, which would be based on the calculation of the ratio as iden- tified in the airport’s bond resolution. The final schedule is the Flow of Funds for the airport, again as defined in the airport’s bond resolution. This would provide the beginning and ending balances for the airport’s operating funds, as well as all activity in each respective fund for the year. Appendix D contains a sample of the items that are generally included in a rates and charges negotiation document. 36 Airport/Airline Agreements—Practices and Characteristics

Common Use Premises Ticket Offices & Bag Aircraft Hold- Jet Baggage Counters Operations Make-up Aprons rooms Bridges Claim C C n/a n/a n/a C C n/aC n/aC C A A C C A A C C A A A A A A A C C C C A AA C C n/a n/a n/a n/a AA n/a n/a n/a n/a n/a n/a n/a n/a n/a A C C n/an/a n/a n/a n/a n/a n/a n/a n/a A A A n/aAA A C n/a n/a n/a n/a n/a n/a C n/a n/a C n/a n/a A n/a A - AIRLINE C - AIRPORT OPERATOR 1AIRLINE shall be responsible for any light fixtures installed by AIRLINE. 2AIRLINE shall be responsible for any electrical fixtures or services installed by AIRLINE. 3AIRLINE shall be responsible for any structure constructed by AIRLINE. 4AIRLINE shall be responsible for any exterior maintenance required from actions of AIRLINE, its employees, or subcontractors. 5AIRLINE shall be responsible for coordinating removal of aircraft to allow for snow removal on airline ramp by AIRPORT OPERATOR; and, AIRLINE shall be responsible for snow removal around the Gate Areas/walkways/work areas, and shall be responsible for determining safety of passages for use by passengers/employees. Air Conditioning Preferential Use Premises Heating Lighting a. Bulb & Tube Replacement1 b. Maintenance1 Electrical Maintenance2 Water a. Distribution b. Fixtures Sewage a. Distribution b. Fixtures Maintenance a. Other than Structure b. Structure3 c. Exterior4 Custodial Service Snow Removal a. Larger ramp area5 b. Gate areas & walkway to aircraft Window Cleaning b. Interior a. Exterior Ramp - Concrete Repair Source: Ricondo & Associates, Inc., May 2009. Prepared by: Ricondo & Associates, Inc., May 2009. C C CC CCC CC C A A C CC n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a C C C C C C C C Exhibit 6. Operating expense responsibilities.

The focus of this chapter is on the terms and conditions of Agreements. Over time, many airports and airlines have found it desirable to enter into Agreements that contain mutual commitments and specify key aspects of their relationships (such as the rules governing airport rate setting and the use of airport facilities). It is important to recognize, however, that Agreements are not required by law. In the absence of an Agreement, airports can establish by ordinance, resolution, tariff, regulation, or other unilateral action the local rules that will govern the airlines’ use of their airport facilities. At many airports, rates and charges, rules controlling the use of terminal space, and other important terms and conditions for the use of the airport have been established in this way.3 In the absence of an Agreement, however, airlines serving an airport retain their right to challenge the legality of the terms and conditions imposed by the airport sponsor. The following are examples of airports that currently operate without Agreements: • Gerald R. Ford International Airport (Grand Rapids) • Phoenix Sky Harbor International Airport • Sacramento International Airport In considering whether to enter into a new Agreement (or extend an existing one), both airports and airlines should understand what the governing rules would be if there were no agreement. We refer to these as the “default” rules and focus on applicable federal aviation law.4 Federal aviation law takes several main forms: (a) statutes enacted by Congress; (b) regula- tions or policies promulgated by the U.S. DOT or FAA; (c) adjudicatory decisions by the U.S. DOT or FAA; (d) judicial decisions considering federal statutes or actions by the U.S. DOT and FAA and, sometimes, applying constitutional principles; and (e) non-binding guidance from the U.S. DOT or FAA. In the absence of an Agreement, federal aviation law provides a number of important default rules that affect federally obligated airports through statutorily mandated FAA Airport Improvement Program (AIP) grant assurances and otherwise.5 These regulatory rules have been the subject of important U.S. DOT rulemaking and adjudicatory action and judicial decisions especially as they relate to airport rates and changes. 38 C H A P T E R 5 Legal Constraints and Issues 3There can also be a mix of approaches at an airport. Agreements governing the use of passenger terminals, for example, can be coupled with the establishment of rates and charges by tariff. Agreements with “signatory” carriers are often paired with ordinances or regulations that govern the terms and conditions applicable to “non-signatory” carriers. 4There is enormous variation in the state and local laws potentially affecting the affairs of airport sponsors. They are outside the scope of this study. 5All the commercial service airports in the United States participate in the federal AIP and are bound by AIP grant assurances. The standard forms of these assurances can be found on the FAA’s website: http://www.faa.gov/ airports_airtraffic/airports/aip/grant_assurances/media/airport_sponsor_assurances.pdf.

We focus on the default rules of four key issues: (1) rates and charges, (2) facility control, (3) capital programs, and (4) legal “boilerplate.” 5.1 Rates and Charges Where no Agreement is in effect, an airport can impose fees for airline use of airport facilities— such as landing fees and terminal rents—but the airport’s rates and charges fees must be “reason- able” and not “unjustly discriminatory.” 49 U.S.C. § 47107(a)(1); Grant Assurance 22. These stan- dards have their roots in constitutional law, but have in recent years been the subject of significant statutory and regulatory action. A quick review of this legal history may provide useful insight into how these rules have developed and could affect future airport-airline negotiations. In 1973, the Supreme Court considered whether an airport operator could levy a “head tax” of one dollar/passenger to help defray its capital and operating costs. The Court held that the Commerce Clause of the United States Constitution requires that rates imposed by an airport operator reflect a “fair approximation” of use of facilities, not be “excessive in relation to the ben- efits conferred,” and not discriminate against interstate commerce. Evansville-Vanderburgh Air- port Auth. Dist. v. Delta Airlines, Inc., 405 U.S. 707, 716-717 (1972) (Evansville). The Court found that the head tax at issue satisfied these constitutional requirements. Following the Evansville decision, the airlines sought relief from Congress. Congress swiftly enacted the “Anti-Head Tax Act” (AHTA) in 1973. The AHTA prohibits “. . . a tax, fee, head charge or other charge on an individual traveling in air commerce . . . ,” but permits an airport operator to charge “reasonable” landing fees, terminal rents, and other fees for the use of the airport.6 Congress did not, however, define what it means to be “reasonable.” In 1982, Congress enacted the Airport and Airways Improvement Act of 1982 (AAIA), which pro- vides for federal funding under the AIP and prescribes the statutorily mandated grant assurances. Each airport sponsor must provide assurances to the FAA that the airport will be available for pub- lic use on “reasonable” conditions and without “unjust discrimination.” 49 U.S.C. § 47107(a)(1); Grant Assurance 22. Once again, Congress offered no definition of what it means to be “reasonable” and offered no specific guidance about what rate-setting methods an airport could use if it had no Agreement. Congress did, however, provide with respect to “unjust discrimination” that air carri- ers making “similar use” of an airport must be subject to “substantially comparable charges,” except for differences “based on reasonable classifications” such as tenants/non-tenants or signatory/ non-signatory carriers. 49 U.S.C. § 47107(a)(2); Grant Assurance 22. Congress also provided that airport rates should “make the airport as self-sustaining as possible” under local circumstances. 49 U.S.C. § 47107(a)(13); Grant Assurance 24.7 Several years later, various major commercial airlines sought a judicial determination that it is inherently unreasonable for an airport sponsor to impose “compensatory” rates and charges without an Agreement, even if the challenged rates only recover the airlines’ fairly allocated share of the actual costs of the airport facilities they use. The airlines claimed Legal Constraints and Issues 39 649 U.S.C. § 40116(b), (e) (“Anti-Head Tax Act”). Congress amended the Anti-Head Tax Act when it enacted 49 U.S.C. § 40117 (the “PFC Act”), which permits the collection and use of passenger facility charges (“PFCs”) at airports to fund certain capital projects. 7Congress has specified that an airport cannot include within its charges any costs covered by federal AIP grants or by PFCs. See 49 U.S.C. §§ 40117(g) & 47107(a)(13). The rate payable by an airline for exclusive or preferential use of a PFC-financed passenger terminal can be no lower than the rate payable by air carriers for the use of a similar facility at the airport that was not PFC-financed. 49 U.S.C. § 40117(g)(3).

that even in the absence of an Agreement, they had a legal right to share in the airport’s non- aeronautical (concession) revenues. The airlines brought suit against Kent County, Michi- gan, the sponsor of the Gerald R. Ford International Airport in Grand Rapids. Kent County established its rates on a compensatory cost-recovery basis. After years of litigation, in 1994 the Supreme Court ruled that compensatory rate-setting is not inherently unreasonable; upheld the challenged fees in Grand Rapids because they were calculated on a “break-even” cost- recovery basis; and observed that the U.S. DOT and FAA (rather than the courts) should adjudicate issues of this kind. Northwest Airlines, Inc. v. County of Kent, Michigan, 510 U.S. 355 (1994) (Kent County). As they had in the aftermath of Evansville, the airlines immediately sought relief from Congress, asking for legislation that would bar the imposition of compensatory rates in the absence of an Agreement. In the FAA Authorization Act of 1994 (FAA Authorization Act), Congress reaffirmed that airport fees may be calculated pursuant to either a compensatory or residual rate-setting method or a combination of the two methods, but again mandated that they be “reasonable.” 49 U.S.C. § 47129(a). Congress provided for expedited review by the U.S. DOT of any airport-airline rate dis- putes.8 Rather than offering any definition of its own, Congress instructed the U.S. DOT to issue guidelines establishing the standards to be used for determining whether an airport fee is reason- able. 49 U.S.C. § 47129(b)(2). In June 1996, the U.S. DOT issued its Final Policy Regarding Airport Rates and Charges (1996 Rates and Charges Policy). 61 Fed. Reg. 31994 (Jun. 21, 1996). The 1996 Rates and Charges Policy contains an elaborate set of rules governing airport rate- setting. Although its details are too numerous to summarize here, several key principles are as follows: • The policy does not govern rates that are set by Agreement with the airlines. • Compensatory rates can be established without airline agreement. • Residual rates cannot be established without an Agreement. • When setting rates without an Agreement, an airport sponsor should consult with the affected airlines before establishing new fees and should provide enough information to the airlines to permit them to evaluate the reasonableness of the proposed new rates. • The composition of rate bases and the methods of cost allocation used to establish compensa- tory rates must comply with detailed U.S. DOT rules when they are set without an Agreement. The 1996 Rates and Charges Policy differentiates between rates for the use of the airfield (which could only recover historic costs) and rates for the use of non-airfield assets (which could be based on “any reasonable method”). In 1997, however, the Court of Appeals for the District of Columbia vacated various provisions of the 1996 Rates and Charges Policy, finding that the U.S. DOT had not adequately justified its distinction between airfield and non-airfield rate setting. Air Transport Ass’n of America v. DOT, 119 F.3d 38, 129 F.3d 625 (D.C. Cir. 1997). The U.S. DOT began, but then aban- doned, curative rulemaking proceedings in response to the Court’s order and has never replaced the provisions vacated by the Court in 1997. There are many unresolved issues under the 1996 Rates and Charges Policy. Two persistent disputes involve (1) whether the rules governing airfield rate-setting (which bar the use of fair market value) must also apply to terminal rate setting and (2) what kinds of rate differentials between signatory rates (under agreements with airlines) and non-signatory rates (imposed without airline agreement) are permissible and not unjustly discriminatory. 40 Airport/Airline Agreements—Practices and Characteristics 8Airlines must file a complaint within 60 days after receiving written notice of a new or increased fee, and the DOT must complete its adjudication of such a complaint within 180 days after it is filed. 49 U.S.C. §§ 47129(a)&(b). As required by Congress, 49 U.S.C. § 47129(b)(1), DOT has promulgated detailed procedural rules governing these expedited rate adjudications. See 14 CFR Pt. 302. The details of these procedures are beyond the scope of this report.

A third controversial issue is whether airport sponsors can impose rates that are designed to bring the demand for the use of congested airport facilities into alignment with their capacity with- out an Agreement. In 2008, the U.S. DOT amended the 1996 Rates and Charges Policy to make explicit the ability of sponsors of “congested airports” to establish rate structures, including “two- part” landing fees, that are designed to provide economic incentives to air carriers to reduce their operations during “peak hours,” increase (or “upgauge”) the size of their aircraft, or use alterna- tive regional airports even if the affected air carriers object. (See Policy Regarding Airport Rates and Charges, 73 Fed. Reg. 40430 [Jul. 14, 2008]). The trade association representing the majority of the largest U.S. commercial airlines has challenged the U.S. DOT’s 2008 amendments, claiming (among other things) that the use of congestion pricing is barred by the 1978 Airline Deregulation Act, 49 U.S.C. § 41713(b), which precludes state or local government from enforcing local laws related to air carrier “prices, routes or services,” but preserves airport proprietors’ rights. Air Trans- port Ass’n of America v. DOT, No. 08-1293 (D.C. Cir.)(pending). Both the U.S. DOT and the major airport trade association, ACI-NA, are claiming that airport sponsors have a proprietary right to use congestion pricing when it is otherwise reasonable and not unjustly discriminatory. A decision by the Court of Appeals was not available at the time this Manual was written. Over the past 15 years, there have only been a few complaints brought to the U.S. DOT chal- lenging airport rates and charges that were set without an Agreement. In many of these cases, there have been subsequent appeals to the U.S. Court of Appeals for the District of Columbia Circuit. These agency and court decisions provide additional guidance on the proper interpre- tation and application of particular provisions of the U.S. DOT’s 1996 Rates and Charges Pol- icy and associated federal statutes.9 They should be consulted, along with the policy itself, when considering what rate-setting methods an airport could use in the absence of an Agreement. The issues considered by the U.S. DOT and the Court of Appeals in these proceedings have included the following: • Whether a landing fee can be based on the fair market value of airfield land; • Whether imputed interest can be charged for projects financed with airport equity; • Whether debt service coverage can be recovered through a landing fee; • What rules govern the allocation of airport roadway costs to airline rate bases; • When the costs of municipal police and fire departments can be reflected in rates; • Whether the costs of public space can be allocated to airline terminal rates if there is no pro- vision for revenue sharing (commercial compensatory rates); • Whether equalized terminal rents can be imposed; and • What kinds of signatory and non-signatory rate differentials are permissible. In evaluating rate-setting provisions that have been offered in a proposed Agreement, both sides (airports and airlines) should take into account what kinds of rate-setting methods the airport could use under applicable default rules if they fail to reach an agreement. The U.S. DOT’s 1996 Rates and Charges Policy and the decisions by the U.S. DOT and the Court in adjudicatory rate-setting proceedings governed by the Policy provide detailed guidance on many issues that are likely to come up during negotiations. The underlying statutory standards (“reasonable” and not “unjustly Legal Constraints and Issues 41 9See, e.g., Los Angeles Int’l Airports Rates Proceeding, DOT Docket OST-97-2329, and Second Los Angeles Int’l Airports Rates Proceeding, DOT Docket OST-95-474, and two related appeals, City of Los Angeles v. DOT, 103 F.3d 1027 (D.C. Cir. 1997), and City of Los Angeles v. DOT, 165 F.3d 972 (D.C. Cir. 1999) (landing fees at LAX); Miami Int’l Airport Rates and Charges Proceeding, DOT Docket OST-96-1965, and Air Canada v. DOT, 148 F.3d 1142 (D.C. Cir. 1998) (equalized terminal rents at MIA); Brendan Airways, LLC v. The Port Auth. of New York and New Jersey, DOT Docket OST-05-20407, and Port Auth. of New York and New Jersey v. DOT, 479 F.3d 21 (D.C. Cir. 2007) (terminal rents at EWR); Alaska Airlines, Inc. v. Los Angeles World Airports, DOT Docket OST-2007-27331, appeal pending, Alaska Airlines, Inc. v. DOT, Case No. 07-1209 (D.C. Cir.) (terminal rents at LAX).

discriminatory”) are, however, inherently elastic, and the precise limits on the rate-setting powers of airport sponsors will in many respects remain subject to case-by-case adjudication. 5.2 Facility Control Agreements typically provide detailed provisions granting signatory carriers exclusive, pref- erential, joint or common use rights to use designated airport premises in exchange for various commitments by the airlines. In the absence of an Agreement, airports must provide access to their facilities on reasonable and not unjustly discriminatory terms. 49 U.S.C. § 47107(a)(1); Grant Assurance 22. If there is no Agreement, airlines have no legal right to exclusive or prefer- ential use of airport premises, but airports will not be advantaged by whatever compensating commitments the airlines might make to gain exclusive or preferential rights. 5.3 Control of Capital Program Agreements can give airlines some influence over or input into airport capital program decision- making (through MII provisions). When airlines agree to provide a financial backstop for the air- port operator’s debt, their Agreement may be coupled with a promise by the airport operator to share its non-airline revenue. In the absence of an Agreement, however, airports retain control of their capital programs and their non-airline revenue, but bear the attendant financial risk. Airports have no right to impose residual rates and airlines have no right to revenue sharing without an Agreement (U.S. DOT 1996 Rates and Charges Policy, ¶ 2.1.1). For further details on business arrangement types see Chapter 2. 5.4 Boilerplate Agreements often contain elaborate contractual provisions containing legal boilerplate spec- ifying such things as payment rules, insurance requirements, environmental conditions, and indemnity obligations. In the absence of Agreements, some airports have imposed ordinance, resolution, tariff, or regulation comparable requirements as a condition of operating at the air- port. The ability of airports to impose such conditions, and their effectiveness in the event of a dispute, has not yet been fully resolved. 42 Airport/Airline Agreements—Practices and Characteristics

The Agreement or the rate ordinance is a fundamental element of the business arrangement between an airport operator and its tenants. As such, it governs the way airports generate revenue and implement their CIPs. How this arrangement functions is an important factor for investors and credit rating agencies as they make their decisions about an investment in or the rating assigned to a particular airport’s bonds. This chapter is designed to provide airport operators and their air- line tenants insight as to how the investment community views the Agreement, and how decisions on how to craft their Agreement influence the rating and investment process. This section considers the five main areas that impact how the investment community views the Agreement: • U.S. bond market conditions • Rate-setting mechanism chosen • Term of the Agreement • Gate usage provisions • Capital spending provisions 6.1 Airports and the U.S. Municipal Bond Market By their nature, airports are capital intensive enterprises. The need for significant up-front investment in major facilities such as terminals, runways, taxiway networks, and road systems requires that airport operators have access to external capital resources to finance such infra- structure. As airports in the United States are generally owned and operated by public entities, an important source of external capital is the municipal bond market. The U.S. municipal bond market is a rather unique entity in the global capital markets. It is a well-established and deep market providing capital resources to a broad array of state and local governmental entities. The Federal Reserve estimates that municipal issuers had $2.2 trillion of debt outstanding at the end of the third quarter of 2008.10 Buyers in the marketplace include individu- als, insurance companies, banks, mutual funds, and other entities that seek the safety of the gener- ally high credit quality of municipal issuers, as well as the advantage afforded by the federal tax-exemption for interest payments on most debt issued by state and local governments. The high credit quality of municipal issuers is borne out by the lack of defaults in the market. All three major bond rating agencies, Fitch Ratings (Fitch), Moody’s Investor Service (Moody’s), and Standard and Poor’s Rating Services (S&P) have undertaken municipal bond default studies that 43 C H A P T E R 6 Investment Community Concerns and Issues 10Flow of Funds Accounts of the United States, Flows and Outstandings Third Quarter 2008, December 11, 2008, Board of Governors of the Federal Reserve System.

have found that municipal default rates are well below those for corporate bonds. In fact Fitch’s 2003 default study found that the cumulative default rate for municipal bonds issued between 1979 and 1997 equaled 0.84 percent. This study covered all municipal debt defaults from Janu- ary 1, 1980, through October 2002, not just debt rated by Fitch. Transportation related issuers had an even lower default rate of 0.04 percent for the same period, with the study indicating no evidence of a default on a general airport revenue bond (GARB) by a major commercial airport. However, defaults have occurred related to special facility debt repaid by the sponsoring airline.11 Moody’s and S&P indicate similar results in their respective default studies, which focused only on transactions rated by the respective firms.12,13 The strong repayment history of the nation’s major commercial airports stems from the central role they play in the nation’s economy and limited competition between individual facilities, as well as the cost recovery nature of their operations and federal grant require- ments that restrict the use of airport resources solely for airport purposes. As Fitch notes in its criteria, “. . . the cost recovery aspect of most airport/airline operating leases allows air- port operators significant flexibility to transfer operating and debt service costs to the tenant airlines, effectively softening the impacts of economic cycles.”14 These factors are reflected in the consistently high bond ratings assigned to GARB debt. The combination of high credit quality and tax-exempt income results in airport operators having access to a deep pool of capital with borrowing costs typically favorable to those available in the corporate bond mar- ket. While solidly in the investment grade spectrum,15 the fact that airport ratings mostly range from the “AA” to “BBB” rating categories indicates there is a modest level of perceived economic and operational risk associated with airport-backed debt. Exhibit 7 shows the cur- rent distribution of senior lien airport bond ratings. Investors in municipal bonds are typically interested in full and timely payment on their bonds and the resultant income stream, rather than total return favored in other markets. Thus, they are generally risk-averse, accepting lower interest rates in return for the consistency and time- liness of the payment stream. The bond ratings assigned to municipal debt are generally designed to measure the risk associated with the ability and willingness of the issuing entity to make its debt service payments in full and on time. In assessing the risk associated with an investment in a GARB transaction, investors and rat- ing agencies look at a variety of factors including (but not limited to) the underlying economic fundamentals of the enterprise, the level of service provided by the airlines, the strength of the airport’s air trade area, the relative market positions of the airlines, the amount of debt issued or expected to be issued by the airport operator, and the financial operations and performance of the entity. They also review two key documents, the bond indenture (or ordinance) and the Agreement (or rate ordinance and permit). The bond indenture outlines the obligations the issuing entity has to its bondholders. General provisions include the pledge of security that will be used to repay the debt, the flow of funds, 44 Airport/Airline Agreements—Practices and Characteristics 11Fitch Ratings, Municipal Default Risk Revisited, June 23, 2003. 12Moody’s Investor Service, Moody’s U.S. Municipal Bond Rating Scale, November 2002. 13Standard and Poor’s Rating Service, U.S. Public Finance Rating Characteristics, March 7, 2008. 14Fitch Ratings, Airports Rating Criteria Handbook for General Revenue, Passenger Facility Charge, and Letter of Intent Bonds, March 12, 2007. 15Fitch describes “investment grade” and “non investment grade” thusly: “The use of credit ratings defines their function: ‘investment grade’ ratings (International Long-term, ‘AAA’ to ‘BBB-’; Short-term, ‘F1’ to ‘F3’) indicate relatively low to moderate credit risk, while those in the ‘speculative’ or ‘non investment grade’ cate- gories (International Long-term, ‘BB+’ to ‘D’; Short-term, ‘B’ to ‘D’) either signal a higher level of credit risk or that a default has already occurred.” Fitch Ratings, Rating Definitions, downloaded from the Fitch Ratings website January 19, 2009.

and the covenants and limitations the airport operator agrees to regarding the setting of rates and charges (rate covenant) and the issuance of additional debt. While this document sets forth the legal agreement between the airport operator and its bondholders, it does not establish the business arrangement of the airport operator; that is accomplished through the Agreement. From the investor perspective, the Agreement provides the framework for how the airport operator will develop the resources necessary to meet its obligations under the bond indenture. The Agreement also establishes the responsibilities of the parties regarding the financial obliga- tions of the airport and allocates the risks of running the enterprise. The major aspects of the Agreement in the eyes of the investment community include the rate-setting mechanism, the length of the Agreement, allocation of gate facilities and usage rights; and stipulations regarding the capital development of the airport, such as the MII provision. 6.2 Rate-Setting Mechanism The rate-setting mechanism is a critical element in understanding the financial operations of an airport. In their respective rating criteria reports, both Fitch and S&P (Moody’s does not have pub- lished criteria for U.S. airports at present) indicate they do not view a particular rate-setting method- ology, be it residual, compensatory, or hybrid, as indicative of higher credit quality, but rather they look to the type of Agreement used in relationship to the airport’s operating conditions.16 Investment Community Concerns and Issues 45 1 4 11 23 16 8 6 2 2 1 2 15 20 28 14 7 3 3 2 10 18 15 23 9 3 1 0 10 20 30 40 50 60 70 AA+ / Aa1 AA / Aa2 AA- / Aa3 A+ / A1 A / A2 A- / A3 BBB+ / Baa1 BBB / Baa2 BBB- / Baa3 BB+ / Ba1 BB / Ba2 BB- / Ba3 B+ / B1 Rating Nu m be r Fitch Moody's S&P Source: Ricondo & Associates, Inc., Summary of Airport Bond Ratings and Other Key Data (as of January 2, 2009). Prepared by: Ricondo & Associates, Inc., May 2009. Exhibit 7. Senior lien airport bond rating distribution. 16Fitch Ratings, Airport Rating Criteria Handbook for General Airport Revenue, Passenger Facility Charge, and Letter of Intent Bonds, dated March 12, 2007; Standard and Poor’s Rating Service, Criteria: Governments: U.S. Public Finance: Airport Revenue Bonds, June 13, 2007.

From the investor’s point of view, the residual methodology provides a strong assurance of revenues, as costs are allocated to the airlines based on level of use. Thus, should one airline reduce service or leave a market, the costs are reallocated to the remaining airlines. This method has been tested at several airports, notably Pittsburgh International following the first bank- ruptcy and subsequent downsizing of the operations of US Airways; at Lambert St. Louis Inter- national Airport following American Airline’s reduction of service after its acquisition of Trans World Airlines (TWA); and, most recently, at Cincinnati-Northern Kentucky International Air- port as Delta retrenched in the marketplace. While the airports all retained positive cash flows and met their debt service obligations, the loss of service and decline in revenues was perceived as diminishing their resources and resulted in rating downgrades from the rating agencies. Still, the ratings remained solidly investment grade, acknowledging the cost recovery structure and economic underpinnings of the facilities. The weaknesses of the residual method appear on the airport operator’s balance sheet, as an airport is usually limited in the amount of excess cash it may generate. This stems from the air- lines providing just the resources needed for airport operations on an annual basis and retain- ing cash resources on their own balance sheets. Furthermore, a residual airport’s debt service coverage ratios tend to be lower, approximating the rate covenant in the bond indenture. Senior lien ratios may be higher due to the support of cash flows for subordinate debt, but the overall ratio will still be near the minimum required in the bond indenture. Also, the lack of excess cash results in higher capital costs and leverage as the airport operator has limited capital resources of its own to commit to a project, which also results in a greater use of capitalized interest dur- ing the construction phase of a development program. In comparison, the compensatory method provides airport operators with greater control over their facilities and higher levels of cash. In exchange, the airport operator takes on a higher level of financial risk. In a compensatory business arrangement, the airport operator assesses rates to the airlines based on the cost of supplying facilities and services without consideration of non-airline revenues such as parking and concessions. In most instances, this allows the airport operator to capture non-airline revenue and use it for airport purposes, including funding of capital projects. This excess cash flow allows the airport operator to build larger financial reserves, post higher annual debt service coverage, and reduce borrowing costs by using internal resources and mini- mizing the need for capitalized interest. However, the airport generally has relatively weaker rev- enue guaranty protection compared with the standard residual methodology; thus, it can be a chal- lenge to allocate costs in a timely fashion should an airline exit the market. Some compensatory Agreements may also lack a mechanism for supplementary year-end revenue requirements to bal- ance airport financial operations or meet rate covenants. Therefore, the airport operator may expe- rience more volatility in its financial operations, to the point of sustaining short-term financial operating loss, particularly in times of economic distress. In its 2008 U.S. Airport Sector Outlook: Six Month Update, Moody’s points out that compensatory Agreements “. . . effectively create a cost-sharing requirement for the airport, forcing it to rely on passenger-related revenues to cover expenses. The airport [operator] must bear a greater risk from passenger declines as this will trans- late into lower revenues and leaner financial margins.”17 Historically, most Agreements followed the residual model, particularly in the regulated era. Since deregulation, which enhanced the cyclical nature of the airline industry, airport operators have sought more control over their facilities with the compensatory or hybrid models becoming more accepted. Residual business arrangements are still prominent at airline hub airports, which allow the airport operator to pass the majority of operating costs to the airline(s) that place the most demand on the facility while also providing a measure of protection should the airline(s) 46 Airport/Airline Agreements—Practices and Characteristics 17Moody’s Investor Service, 2008 U.S. Airport Sector Outlook: Six Month Update, August 2008.

falter. Compensatory approaches are favored at airports that are largely oriented to serving demand created by the underlying market and less reliant on any one airline. Hybrid business arrangements have been used at both airline hubs and O&D oriented airports. While a hybrid business arrangement can allow the airport operator to accumulate surplus funds at a higher level than a fully residual approach, the airport operator usually cedes some control over capital plan- ning and shares some revenues with the airlines in exchange for the airlines’ financial backstop— a balance of the “risk” versus “reward.” 6.3 Term of the Agreement The investment community also pays close attention to the length of the Agreement in rela- tion to the term of the bonds outstanding, as the need to periodically renegotiate the Agree- ment may result in changes to an airport operator’s risk profile. Historically, Agreements ran for rather long terms, up to 30 years. The long terms were based on the regulated nature of the airline industry that existed through the late 1970s, the rather stable relationships that the regulations engendered between an airport operator and its tenants, and the perceived assur- ance the long-term commitments provided to investors that the airport operator would be able to repay its debt. In the time since the deregulation of the airlines, the length of Agreements has shortened signif- icantly, with many Agreements now running for just 5 years and several having rolling 30-day opt- out provisions. The shorter terms evolved in response to the increasing volatility in the airline indus- try as both airport operators and airlines sought greater flexibility to adjust their operations, and the Agreements that governed them, as economic conditions warrant. As S&P points out in its criteria piece, “Air carriers may not want to maintain service in an area generating intense interline compe- tition or low yield. Conversely, airport operators want to avoid being saddled with unused terminal space resulting from tenant bankruptcy or routing changes.”18 Like the change to hybrid and compensatory Agreements, the shorter term provides an air- port operator greater control over its facilities and reduces certain risks, such as the ability of a financially struggling airline to retain gates for competitive reasons at the expense of the air- port. However, the shorter terms of the Agreements expose airport operators to the volatil- ity of the airline industry to a greater extent as the Agreements need to be renegotiated more frequently, potentially at a time of extreme financial distress at the airlines. Furthermore, the shortened terms reduce the assurance that the costs of major capital projects will be recov- ered over time as an airline’s obligations expire along with the Agreement, allowing it to leave before debt is retired (unless there is a separate agreement binding the airline to the repay- ment of a specific project) should competitive pressure, costs, or other factors deem a facil- ity undesirable. The increased exposure to the volatility of the airline industry increases the importance of operating cash and other sources of liquidity on an airport operator’s balance sheet as a means to absorb changes in cash flow without disrupting its financial operations and debt service obligations. Also, it places greater emphasis on management’s ability to appropriately scale its capital program to the marketplace or risk placing too great a burden on its cost structure. Still, Fitch indicates that “. . . the flexibility afforded airports by the shorter duration of these Agreements often offsets (the risk associated with airline industry volatility).”19 Investment Community Concerns and Issues 47 18Standard and Poor’s Rating Service, Criteria: Governments: U.S. Public Finance: Airport Revenue Bonds, June 13, 2007. 19Fitch Ratings, Airport Rating Criteria Handbook for General Airport Revenue, Passenger Facility Charge, and Letter of Intent Bonds, March 12, 2007.

6.4 Gate Assignments and Usage Investors also consider the gate usage provisions of an Agreement to determine the efficiency of the terminal facilities, the ability of the airport to accommodate demand from the airlines, the potential need for capital expenditures to expand facilities, and the financial risk the airport operator faces regarding underused or unused gates in the event an airline reduces or eliminates service. The deregulation of the industry and the advent of the hub and spoke network raised awareness of the importance of the assignment of airport gates. Historically, most gates were assigned to an airline on an exclusive basis for the term of the Agreement. This largely reflected the joint venture arrangement with the airlines and the regulatory environment that guaran- teed the airlines a return on their investment. This system worked well as routes were assigned by the government and competition was limited. As the airline industry became increasingly competitive as the regulatory strictures were removed, the need for flexibility in gate assignments became apparent. As airlines eliminated direct service from non-hub cities, their need for gates at certain airports decreased. However, in some instances there were economic incentives for an airline to retain the gates to prevent competitors from entering the market. Thus, for an airport operator to accommodate a new entrant it may have been forced to build additional facilities that it may not need in the long term. At the other end of the spectrum, high demand airports found themselves unable to accommodate new airlines and service due to the exclusive nature of their leases, even if some gates were underutilized, also prompting a need for additional facilities. At the prompting of the federal government, which wanted to promote competition through its grants, airport operators began to move to preferential and common-use gate assignments. For bondholders, preferential Agreements maintained some assurance of cash flow because an airline remains responsible for paying for the use of the gate while the airport operator gained the option of placing a second airline on the gate if needed, or to retake and reassign the gate if the incumbent airline falls below minimum usage requirements. Common-use provisions provide an airport operator almost complete control over its gate facilities, as any airline may be assigned to a gate at a particular time, though the airport assumes the risk related to unoccupied or underutilized gates. The shift away from exclusive use gates, along with the adoption of compensatory pricing prac- tices for terminal space, which tend to be higher than residual rates, serves to emphasize the effec- tive use of these facilities. Also, the financial pressures placed on the airlines reduced their ability to absorb costs for underutilized assets. Thus, with the exception of a few airports that have signif- icant grants of exclusive gates remaining, gate assignment provisions have generally shifted in a manner that provides greater control to the airport operators. 6.5 Capital Planning The last major elements of interest to the investment community in the Agreement are the provisions governing the capital spending of the airport. These are important to understand- ing an airport operator’s ability to undertake capital programs to address demands placed on its infrastructure, accommodate new entrants and service, and maintain its facilities to a sat- isfactory level for the traveling public. Major capital programs are complex, requiring exten- sive lead time to meet regulatory requirements, address political issues, and establish funding sources. Thus, airport planning is long term in nature. As a result, the plans of airport opera- tors often run into opposition from the airlines, which are notoriously focused on the short- term cost due to the volatility endemic to the industry. The key item regarding capital programs is the MII provision, which provides airlines input over the capital program. To balance risk versus control, residual Agreements typically have 48 Airport/Airline Agreements—Practices and Characteristics

strong MII provisions, from the airlines’ standpoint, as the airlines provide the financial back- stop to the airport’s operations. A strong MII may limit the airport operator from taking on debt in certain circumstances, as the need for airline approval of projects could hinder the ability of the airport operator to implement certain capital improvements. Still, gaining the acceptance of the airlines is usually viewed as a favorable credit characteristic, because it demonstrates the air- lines’ commitment to serving a facility. As airports operators have gained greater control over non-airline generated revenues, they have also sought to reduce airline control over capital programs. As Fitch notes in its criteria, “An airport [operator] that employs a compensatory Agreement may have taken on more responsi- bility for its financial operations and the risk of economic disruption than the airlines, thus it may be more appropriate for management to maintain greater control over its capital planning with a less restrictive MII provision or the absence of one entirely.”20 While this gives airport operators greater leeway in planning their capital programs, it also comes with the responsibility to assure the plans match the needs of the underlying service area, lest an entity become overburdened with facilities and debt. Thus, in these instances, investors are likely to pay greater attention to cover- age generated by the airport’s financial operations and the amount of liquidity and leverage held on the airport operator’s balance sheet. Airport operators judged to be taking on leverage at a level higher than the market could support or that may prove unsustainable in the event of an eco- nomic downturn may see lowered ratings and higher interest rates as a result. 6.6 Limitations While the Agreement is an important consideration in the making of an investment or rating decision, there are limitations in its application that are also evaluated. One limitation is that the Agreement provides assurance to bondholders only when it is in force. While airport operators may instate rates by ordinance upon the expiration of an Agreement, providing a means to con- tinue generating revenue, the obligations of the airlines to the airport operator are greatly dimin- ished while they gain the ability to leave the market with very little notice. In this situation, the airport operator assumes all the economic risk of the enterprise, a credit factor that is generally reflected in the rating and borrowing costs of the operator. A second limitation occurs when an airline enters bankruptcy proceedings. The Agreement is usually treated as an executory contract, which a bankrupt airline must either assume or reject dur- ing its reorganization. In the period prior to making a decision to assume or reject the lease, the airline must fulfill its obligations under the Agreement following the date of the bankruptcy filing. If assumed, the airline must fulfill the terms of the Agreement in their entirety and make up any payments missed prior to filing for bankruptcy protection (pre-petition debt). If rejected, the air- line must vacate its premises with the airport operator becoming a creditor of the estate with a claim based on the provisions of the bankruptcy code.21 While this is an either/or proposition, the airline may reject the lease and negotiate revisions in a new Agreement, that would then need the approval of the bankruptcy court. There is a variation to this process, whereby the bankrupt airline assumes the Agreement in its entirety and assigns its interest to a third party that is willing and able to perform the debtor’s obligations under the lease. An assignment may be allowed despite any limitations or prohibitions Investment Community Concerns and Issues 49 20Fitch Ratings, Airport Rating Criteria Handbook for General Airport Revenue, Passenger Facility Charge, and Letter of Intent Bonds, dated March 12, 2007. 21Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, PC, Advisory, Public Finance and Bankruptcy, Analyzing the Impact of an Airline Bankruptcy on Airport Special Facility Revenue Bonds, December 2002.

contained in the lease. As in a straight assumption, the debtor or the third party must cure all defaults and assure future performance.22 Use of this mechanism may result in an auction process, as the bankruptcy code allows other entities to enter counteroffers to ensure that an assign- ment attains the maximum resources possible to repay the bankrupt entity’s debt.23 Such a process occurred in American Trans Air’s (ATA) 2004 bankruptcy, where AirTran Airways (AirTran) entered an agreement with ATA to purchase the debtor’s gates at Chicago Midway Airport. When other airlines expressed interest in the gates, the court established an auction process through which Southwest Airlines offered a transaction that was accepted by the court as superior for ATA’s cred- itors.24 Should an auction process occur in a bankruptcy that results in liquidation after the debtor airline ceases operations, the facilities leased to the bankrupt airline may lay dormant until the court completes the auction process and the new airline begins operations. Finally, while the Agreement provides the basis for the business arrangement of the airport, it does not guarantee that passengers will come through the door. As S&P points out in its criteria, “While use agreements may provide an additional level of comfort if a particular airline ceases to operate or alters its routing structure, the inherent demand in the air traffic market remains the ultimate security for the bondholder. A strong market will continue to attract airlines to serve that demand, while even the strictest use agreement will not, in and of itself, ensure the timely payment of debt service.”25 Investors and rating agencies focus on the core economic fundamentals of an airport as the major inputs in their respective assessments of an airport operator’s credit status. As the Agree- ment plays a key role in turning these economic fundamentals into the resources that support the operation of the facility, airport operators should carefully evaluate how the Agreement aligns with the underlying demand from the service area and the operations of the airlines. Agreements that allow the airport to capture the resources generated by the service area in an efficient manner that benefits both the operator and the airlines serve to enhance the credit stature of an entity, while Agreements that do not align the interests of the market, operator, and airlines can undermine the credit fundamentals of an entity. To assist both airport operators and airlines in the negotiation process and to recap much of what has been presented in this Part 2, Exhibit 8 presents a checklist of activities suggested to be completed before and during negotiations. 50 Airport/Airline Agreements—Practices and Characteristics 22Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, PC, Advisory, Public Finance and Bankruptcy, Analyzing the Impact of an Airline Bankruptcy on Airport Special Facility Revenue Bonds, December 2002. 23Fitch Ratings, Chicago, Illinois: Chicago Midway International Airport (Rating Report), November 23, 2004. 24Fitch Ratings, Chicago, Illinois: Chicago Midway International Airport (Rating Report), November 23, 2004. and Fitch Ratings, Fitch Comments on Southwest Airlines’ Purchase of Chicago Midway Gates (Press Release), December 17, 2004. 25Standard and Poor’s Rating Service, Criteria: Governments: U.S. Public Finance: Airport Revenue Bonds, June 13, 2007.

Investment Community Concerns and Issues 51 Source: Ricondo & Associates, Inc., September 2009. Prepared by: Ricondo & Associates, Inc., September 2009. Exhibit 8. Negotiation checklist.