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Mar172008

« Invoking the Force Majeure Clause: Oil Taking Its Toll »

...and Thinking About Northwest - Delta

As I prepared to write this week, I had outlined a piece around the NCAA basketball tournament generally and Selection Sunday specifically. I was going to talk about how the Delta-Northwest deal, destined for a #1 seed a month ago had become a “bubble” deal over the past month because of a less than stellar end to the conference schedule and “one and done” in the conference tournament. And then I was prepared to place them in the last 4 teams out group.

But rather than just isolate Delta-Northwest, I think it is time for the industry to think about consolidation in yet another way. Typically we think about consolidation as two entities combining through merger activity. But there is financial consolidation as well. It is similar to what we experienced during the 2002-2006 period where an industry contracts on its own volition. It is probably time to begin another round of contraction as the price of oil makes it very difficult for the industry to maintain its current service offerings.

Introduction to Force Majeur for Those on Capitol Hill
and a Refresher for US Airline Labor

From where I sit, the NCAA tournament will make great theater as always but will pale in news as to what I see coming for the US airline industry. In my last blog post, I purposefully left the piece hanging on an issue for labor and the politicians to seriously consider: “Politicians and labor should think real hard about the fallout that could stem from the current economic environment [read to include high oil prices] versus what the perceived fallout could be in a consolidation scenario”.

As the market opened this morning, oil traded near $112 per barrel. Whereas the price has pulled back from those highs, it is becoming clearer that oil is going higher as the highs get higher and the lows get higher. Heeding warnings from the industry that capacity will be closely examined at these prices, I began to write this piece.

Then as I was writing, I did my usual check of the headlines as the day wore on. In one check of the day’s news, I read, as everyone should when you are not reading here to steal a Maxon line, a blog post by David Field of Airline Business on his blog named appropriately Left Field. Mr. Field cites quotes directly from Delta’s Anderson, Northwest’s Steenland and Continental’s Kellner each questioning the size of their respective networks in the face of $105 per barrel oil.

Defining Force Majeure

Typically we do not like to talk about force majeure issues in the industry, but I am thinking it is time. Wikpedia defines force majeure as:

Force majeure (French for "greater force") is a common clause in contracts which essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as war, strike, riot, crime, act of nature (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract. However, force majeure is not intended to excuse negligence or other malfeasance of a party, as where non-performance is caused by the usual and natural consequences of external forces (e.g., predicted rain stops an outdoor event), or where the intervening circumstances are specifically contemplated.

Time-critical and other sensitive contracts may be drafted to limit the shield of this clause where a party does not take reasonable steps (or specific precautions) to prevent or limit the effects of the outside interference, either when they become likely or when they actually occur. A force majeure may work to excuse all or part of the obligations of one or both parties. For example, a strike might prevent timely delivery of goods, but not timely payment for the portion delivered. Similarly, a widespread power outage would not be a force majeure excuse if the contract requires the provision of backup power or other contingency plans for continuity.

A force majeure may also be the overpowering force itself, which prevents the fulfillment of a contract. In that instance, it is actually the Impossibility defense.

The understanding of force majeure in French law is similar to that of international law and vis major as defined above. For a defendant to invoke force majeure in French law, the event proposed as force majeure must pass three tests:

Externality

The defendant must have nothing to do with the event's happening.

Unpredictability

If the event could be foreseen, the defendant is obligated to have prepared for it. Being unprepared for a foreseeable event leaves the defendant culpable. This standard is very strictly applied.

Irresistibility

The consequences of the event must have been unpreventable.

A Non-Lawyer Discussion of Force Majeure

Force majeure (French for "greater force") is a common clause in contracts which essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as war, strike, riot, crime, act of nature (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract.

Name any airline that spent time in bankruptcy and was required to file a plan of reorganization that correctly estimated the price of oil in that plan. United assumed $55 per barrel and that was $50+ per barrel ago. Northwest just recently emerged and it assumed oil $40+ per barrel ago.

Based on the assumed price per barrel of oil, contracts were entered into with the regional affiliates of the major carriers. The price of oil has long been described an uncontrollable expense for the airline industry. Is this an act of nature, I do not know. What I do know, is that this rise in the price of oil is beyond the control of the industry. Moreover, this recent price push makes oil more expensive than it was on an inflation adjusted basis in the early 1980’s and we know that the period will always be defined as an oil crisis.

However, force majeure is not intended to excuse negligence or other malfeasance of a party, as where non-performance is caused by the usual and natural consequences of external forces (e.g., predicted rain stops an outdoor event), or where the intervening circumstances are specifically contemplated.

There is no negligence here by the industry or malfeasance by anyone. This is the market at work. The causes for the oil price increases are many but cannot be isolated to any one catalyst. And none of this is as predictable as rain on a hot summer night.

Time-critical and other sensitive contracts may be drafted to limit the shield of this clause where a party does not take reasonable steps (or specific precautions) to prevent or limit the effects of the outside interference, either when they become likely or when they actually occur.

To say that the industry has not taken reasonable steps to prevent or limit the effects of the outside interference would ignore the painful attempts to address cost structures that were simply not sustainable. As Jamie Baker pointed out last week in his research note, since 2002, the price of oil will have increased some $25 billion for the US industry while savings from labor over the same period amounts to $7 billion.

Through the restructuring period and practices that continue today, the industry cut costs to combat a declining revenue environment and to address the rising cost of oil. The industry has used hedges; pared domestic capacity as a way to reduce exposure to an unhealthy domestic market; increased international capacity as a way to increase revenue; cut back on amenities; cut distribution costs to a minimal level; reduced ownership costs; cut employee wages; improved employee productivity; improved asset utilization; terminated pensions; outsourced flying; outsourced maintenance; outsourced administrative activities; and experimented with hub structures to name a few of the hundred of cost cutting activities that have been employed.

Most, if not all, reasonable steps have been taken to prevent or limit the continued losses for the US industry – except for that outside interference called oil.

Included in the definition: A force majeure may also be the overpowering force itself, which prevents the fulfillment of a contract. In that instance, it is actually the Impossibility defense. As for the externality, the industry has nothing to do with the event’s happening. As for unpredictability, this industry has done everything it can do to counteract its influences. As for irresistibility, the consequences of the oil price rise were not preventable.

Delta and Northwest

About one month ago, I remember Bob Fornaro, CEO of AirTran Airways, referring to proposals made to his pilots in an oil-denominated way. Like Fornaro, Messrs. Anderson and Steenland I only hope that you tell your pilots and all other employees that the terms of the agreement you made in order to have a single collective bargaining agreement in place are now off of the table. You made an agreement where some of your pilots would receive 30% pay increases at $85-90 oil, surely those agreements should not be made at $105 oil. Invoke force majeur.

$20 per barrel ago, you said that your networks would be largely kept intact. Now today you seem to be hinting that the size of your networks may need to be reconsidered. Let’s just face the fact that there are too many regional carriers and too many hubs and as a result too much money being spent on serving communities that cannot economically support the frequency of access to the air transportation system today. Cutbacks like those Doug Parker of US Airways suggested were probably unavoidable at some point and at $105 oil, well……invoke force majeur.

In each case, these suggested actions seem prudent and can easily be explained by an unpredictable externality whose consequences could not have been predicted by you. Invoke force majeur.

Consolidation is still right. But as everyone has said it has to be the right deal for all stakeholders and given the externalities facing the industry, much harder choices will now have to be made.

More to come.

Reader Comments (8)

According to Aviation Week magazine"s Market Focus section, the 6 largest US carriers (American, Continental, Delta, Northwest, United and US Airways) had a domestic load factor exceeding 80% for the last calendar year. The problem isn't capacity. It is the lack of price leadership by the managements of these carriers.

03.18.2008 | Unregistered CommenterAnonymous

Dear Anonymous

It is certainly your perogative to make sweeping analysis using domestic load factors as your guide. What about Southwest, jetBlue, AirTran, Frontier, Alaska and Midwest to name some others. Don't you think that the industry structure that is highly fragmented and hypercompetitive has anything to do pricing?

03.18.2008 | Unregistered CommenterSwelbar

I believe the legal concept your attempting to apply....as YOU see it...is better known as "Horse Manjure".

Definition of Horse Manjure..from the Old English meaning...
(noun) fertilizer, nitrogenous waste
(adjective) worthless, of little value
(adverb) to mislead. ie "you're full of horse manjure:.

The rise in oil prices is not sudden and is simply part of the business environment to which ALL parts of the world economy must adjust. To the extent its impact on demand can be predicted, a competent management team will adjust operations accordingly. Scale back ops, deploy fuel efficient technologies, etc. To do otherwise is negligent.

So if customers are unwilling to pay higher input costs then operations should be scaled back to better match supply with those customers who are willing to pay the higher costs.

I'd like to get my hands on AAdvantage, sell it off, then light a match.

Can I get that in the next round of Bankruptcy if the airlines file under your legal concept of Horse Manjure?

03.19.2008 | Unregistered CommenterDirt Farmer

I must admit my disappointment at seeing your remarks concerning force majeure. If airlines could have survived the post 9/11 tumult (albeit in their current bruised and battered form) without invoking such a clause with their suppliers, regional affiliates, labor unions, etc... one would think that the high barriers to exit that you have discussed would once again prevent their exit from the market.

An industry which shirks its contractual obligations in such a manner would certainly not be held in high esteem on the global markets which are so crucial to the future of U.S. aviation. What suppliers would want to do business with U.S. carriers if foreign carriers who have not used such dubious legal manouvres are in the marketplace?

While I've re-read your post several times, I still cannot tell if you are advocating the wholesale abrogation of labor agreements using this clause or merely espousing the view that they should be renegotiated in the current economic context. In the past you have attempted to balance the needs of labor in the context of the greater airline picture. I hope that still remains the same.

03.19.2008 | Unregistered Commenterblackbook

Blackbook,

Thanks for your reappearance. To my chagrin, you caught me in a duplicitous statement. Thus I have taken pause to reevaluate.

In this post, quite honestly, it has nothing to do with labor directly. Indirectly, I suppose it does.

Your second paragraph calls me to the mat on my earlier statements regarding the barriers to exit. I firmly believe that we have contracted too much domestic capacity to the regional providers. While the regional industry has taken the rightful advantatge of labor arbitrage during the restructuring period, fuel is now the highest expense for the industry. If regional capacity was uneconomic at $50 per barrel - or approaching uneconomic based on what people are willing to pay - then buying regional capacity at $110 per barrel makes no sense.

I agree that the world thinks of our interpretation of restructuring as wrong. But, it is the rules of the game we possess. You use the word dubious...

My question to you Blackbook: Why should Skywest have a higher market cap than an industry provider that contracts with a regional industry carrier? This has been true for years. Something is wrong and this again suggests something is wrong with the current industry structure.

When I look at the industry today, here's what I do NOT see:labor costs as an area of saving except for productivity buying wage increases; distribution costs as the magic bullet seeing how significant costs have been wrung from all respective airlines; maintenance costs as a savings area particurlarly when the cost of materials are going up...fuel is uncontrollable; therefore I only see regional carrier expenses as approching $16 billion for the industry as a place to cut.

For guys like Oberstar, this is overspend and cross-subsidize. The problem is that they do not see that.

03.19.2008 | Unregistered CommenterSwelbar

Blackbook

And further, if I were on the Boards of Delta and Northwest I would want to reconsider the terms of the deal made with labor $20 per barrel ago.

03.20.2008 | Unregistered CommenterSwelbar

When Delta sold its $50 dollar a barrel fuel hedges to raise capital and make its balance sheet look better its management threw caution to the wind assuming they wouldnt need them and oil would come down. Guess what... Maybe they acted prematurely eh? Maybe they couldnt pass the force majure acid test this go around if need be.

03.22.2008 | Unregistered CommenterAnonymous

Anonymous

Yes the Delta action then was questioned, but if memory serves me right it was about bolstering liquidity. The actions being suggested by Delta and others today are about the same thing.

Hedges require capital and I believe that 2008 will be about capital conservation. Even the low cost carriers are selling aircraft and positions to bolster liquidity. This is an industry issue and not an individual carrier issue.

03.23.2008 | Unregistered CommenterSwelbar

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