Drone Financing Opportunities Emerge As FAA Creates New Drone Regulations

The term “drone,” in regulatory parlance, refers to an unmanned aircraft system (“UAS”). A UAS is typically controlled either by a pilot using a remote control device on the ground or by on-board computers. Each UAS constitutes an “aircraft” (as defined in Section 1.1 of the Federal Aviation Regulations (“FAR”)). Title 49 defines “aircraft” as “any contrivance invented, used, or designed to navigate or fly in the air.” See 49 U.S.C. '40102(a)(6) ' U.S. Transportation Code. Since a small unmanned aircraft (“UA”) is a contrivance that is invented, used and designed to fly in the air, a UA is an aircraft under title 49.

The Federal Aviation Administration (“FAA”) currently defines a UAS as “[a]n unmanned aircraft and its associated elements related to safe operations, which may include control stations (ground, ship, or air-based), control links, support equipment, payloads, flight termination systems, and launch/recovery equipment.” In proposed regulations, a UA is an aircraft operated without the possibility of direct human intervention from within or on the aircraft. See Proposed 14 C.F.R. Part 107.

Recreational-Use Drones

From the FAA's perspective, two types of drone use exist ' recreational and commercial. The FAA often refers to certain recreational or hobby use drones more officially as “model aircraft.” You can purchase these drones in the consumer markets and their operations do not typically serve a business purpose. As the designations indicate, purchasers enjoy flying them for sport (e.g., racing), recreation or as a hobby. Prices of these drones start at less than $40.

Recently, however, the FAA mandated that, if the drone weighs over one-half pound (0.55 pounds) and under 55 pounds (on takeoff, including everything that is onboard or attached to the aircraft), the user must register the drone with the FAA. See http://tinyurl.com/hxzx35a. Like any aircraft registered at the FAA, each drone must bear a U.S registration number (called an “N number”). The FAA calls these drones small Unmanned Aircraft (“sUA” or “sUAS”).

No other special federal license, exemption, approval or certification is required to fly this type of drone if the owner is a “citizen of the United States” and uses it for recreational or hobby purposes. The orderly registration process, described below, has already encountered litigation that seeks to enjoin the registration requirement for recreational drones based on the Interim Final Rule for drones discussed below. See Petition, filed in the United States Court of Appeals for the District of Columbia, USCA Case #15-1495 Document #1590543, available at http://tinyurl.com/zpzg4em.

Commercial-Use Drones

Non-recreational/non-model aircraft use defines a commercial use drone. Prices of commercial-use drones currently range from approximately $2,000 to $140,000 each (but these sums vary depending on specifications, market conditions, customization and functionality). These drones can weigh less or more than 55 pounds. Under 55 pounds, this commercial use still qualifies as an sUA, even if purchased at a much higher price point than a recreational or hobby use drone.

Thus, each operator should carefully analyze whether its commercial use drone under 55 pounds requires a federal exemption. One clear indicator arises when the operator holds out (i.e., seeks) or receives compensation for: 1) providing drones to third persons for their use (e.g, rentals); 2) offering drone flight services as a “turnkey” drone operators; or 3) using the drones directly in and for their own business enterprises.

These sUAs serve business functions despite their relatively small size. Unlike recreational-use drones, the commercial use of drones requires the operator to obtain an exemption from the FAA to conduct flight operations (described below). The FAA also subjects commercial use drones to safety criteria that stem from its primary mission to ensure safe operation of aircraft in the National Airspace System (“NAS”).

Today, businesses use drones for videography and photography; imaging of mining and construction sites; real estate surveying; aerial advertising; rail bed, power line and canal inspections; auto or maritime traffic control; movie, archaeology and geology exploration and mapping, sports and television production; agricultural functions such spraying insecticide on crops (e.g., an unmanned helicopter (UAS) designed by Yamaha Motor Corporation, U.S.A. and recently certified by the FAA); package delivery; firefighting; law enforcement and much more. In short, drones have ascertainable value in business, the public sector and industry; and should become increasingly important ' even mission critical ' in a broadening range of commercial applications.

It should not be a surprise that, by 2035, one source estimates that 175,000 drones will be placed in commercial service. The FAA expects approximately 800,000 and 1.9 million new sUAS to begin operating in the NAS in 2015 and 2016, respectively. The FAA also estimates sales of 600,000 drones for use for non-recreational purposes in 2016. See http://tinyurl.com/z8349qh.

Drone Regulatory Primer

The rapid proliferation of drones has posed a huge regulatory challenge for the FAA, as it tries to catch up with technology, promulgate rules to guide drone safety, and enforce the applicable FARs. Under its regulatory authority prescribed by Congress, the FAA ushered in the legal use of commercial use drones on June 10, 2014, when it approved the first drone operations over land in the United States for civil UAS operators who have been granted operational authority by exemption in a specific waiver process. See http://tinyurl.com/l4l3r4q.

Three pillars (among others) buttress current efforts by the FAA to regulate the use of commercial drones:

1. FAA Safety Mission

As noted above, the FAA's highest priority is to provide standards to regulate commercial use drones consistent with its mission “to provide the safest, most efficient aerospace system in the world.” See http://tinyurl.com/jv2nt76. This element is crucial in part because every time someone flies a drone, he or she becomes a pilot in the NAS commanding an aircraft under FAA jurisdiction. Aware of challenges posed by UAS integration in the NAS, Congress may grant more authority to the FAA to regulate drones on a risk-based approach under the Aviation Innovation, Reform, and Reauthorization (AIRR) Act of 2016. See http://1.usa.gov/1O6HmMh.

An individual operating an sUA for commercial purposes must be a certificated pilot. In contrast, the FAA has not required that individuals who operate a UAS exclusively for recreational flights to hold a pilot certificate. Instead, the owner of the UAS must obtain a “Certificate of Aircraft Registration” for registration of these UASs. Registration started Dec. 21, 2015 for new sUAS before their first use outside. On Jan. 6, 2016, FAA Administrator Michael Huerta, announced that 181,000 drones have been registered as of Dec. 21, 2015. Enforcement tools include civil penalties of between $27,500 and $250,000 plus criminal action leading to jail time of up to three years. See http://tinyurl.com/hxzx35a.

Each drone pilot must be a citizen of the United States and adhere to a developing body of safety rules and regulations to be set out in a forthcoming Part 48 of the FAR. On Dec. 16, 2015, the FAA published the sUAS “Interim Final Rule” with respect to Registration and Marking Requirements. The rule became effective on Dec. 21, 2015 based in part on a final report issued November 21, 2015 by an FAA appointed Task Force. Ironically, the FAA is likely to authorize non-pilots to operate drones for commercial purposes in the future provided they meet prescribed criteria and complete recurrent training.

2. Exemption; Proposed Rulemaking

Section 333 of the FAA Modernization and Reform Act of 2012 (“FMRA”) authorizes the FAA to grant exemptions to the general ban on commercial UAS use (a “' 333 Exemption”) if the FAA determines that an operator and its UAS can operate safely within the NAS. On Feb. 15, 2015, the FAA published a notice of proposed rulemaking (“NPRM”) outlining a protocol for authorizing commercial use of sUAS (those drones weighing up to 55 pounds). Once the final version of the NPRM goes into effect (expected this year), it is anticipated that operators of sUAS will not be required to individually petition the FAA for a ' 333 Exemption, unless the scope of the intended UAS operation otherwise exceeds the limitations that will be set forth in the final version of the NPRM.

3. Certificate of Waiver or Authorization

An operator conducting commercial UAS operations pursuant to a ' 333 Exemption (whether under or over 55 pounds) must also obtain a UAS Certificate of Waiver or Authorization (“COA”). See http://tinyurl.com/hrsmobk. The FAA Air Traffic Organization, applicable to the operator's particular UAS, issues the COA for that operator's specific purpose within in a designated area (i.e., for operations within a particular block of the NAS). The COA helps identify operators and, to some degree, track their activities.

According to current FAA guidelines, however, drones operated for commercial purposes may receive a “blanket” COA provided that they weigh less than 55 pounds (total weight with payload), fly only during the day under 200 feet in altitude, and fly within the operator's direct line of sight at prescribed distances from airports.

Financing Drones

Given the explosive (perhaps unrivaled) growth and broad applications of a category of equipment, this article now turns to evaluate whether financiers can and will provide financing of U.S. commercial use drones (i.e., excluding recreational use drones).

Financing commercial use drones merges technology, finance, environmental, privacy, business and aviation regulation within a setting of constant change and expanding regulation under local, state and federal laws. Arguably contrary to the preemption power of the FAA, states and local authorities promulgate ordinances, rules and regulations that create a “patchwork quilt” of differing restrictions as noted below. The FAA has stated that such actions could severely limit the FAA's flexibility in controlling the airspace and flight patterns, and ensuring safety and an efficient air traffic flow.

Undaunted by these challenges, potential borrowers or lessees (“customers”) and other interested businesses see nearly unlimited potential to exploit drones in commercial use. Accordingly, it is reasonable to assume that some of them will seek financing to further their business goals. It follows that operators will need legal and other advice to navigate increasingly complex laws, ordinances, rules and regulations, assist in financier diligence and comply with covenants on lawful commercial drone use.

Though many companies already advertise their drone-leasing capabilities on the Internet, many other financiers cannot or will not make a business case for drone leasing and lending. These financiers shun drone financing due to the equipment's: 1) novelty; 2) low original cost (limiting profit potential); 3) atypical approval, diligence and documentation processes; 4) high operational risk of liability to third persons; and 5) absence of residual/collateral value.

Few financiers can overcome these concerns unless the customer has excellent credit upon which a financier can rely. Unavoidably, it is the same type of customers that may not want or need financing for its drones. In contrast, smaller businesses may elect to preserve capital as they build their fleets and drone offerings. For example, a drone provider that operates drones to provide photography and surveillance services might lease drones or borrow to buy them literally to get its drone business off the ground.

Financing Options

A financier can adapt currently accepted lending and leasing structures to accommodate the financing of drones, including the following:

Master Leases: Direct Leasing to Drone Providers and Other Operators

A lessor can enter into a single source lease of a drone with a lessee where the lessor or drone owner, manufacturer, vendor or fabricator transfers possession and control for a period of time and for consideration under Article 2A of the Uniform Commercial Code (“UCC”). Like other leased assets, a lessor can lease each drone under a master lease structure where it puts one or multiple drones on one schedule depending on the type and timing of delivery of each drone.

A lessor should take some comfort by structuring a “finance lease” under Article 2A to enhance its “irrevocable and independent” right of payment, which should have value ' at least from good credits. Of course, they should also include typical “hell or high water” language in the equipment lease.

For drone providers, various sublease or service agreement structures will enable them to operate drones for the end-user subject to the FARs and other applicable laws. Tax leases may be possible, at best modest residual value and useful life runs counter to the requirement that lessors take a constant level (i.e., 15%-20%) residual value risk throughout the lease term and receive back the leased property with substantial useful life remaining (i.e., 15%-20%). Limited use property and other considerations may make them too challenging due to frequent customization of drones.

Lending Money to Purchase Drones

A drone provider may also borrow money from an equipment (or other) lender. The lender can treat this transaction like other technology equipment loans, but with a twist for the elements unique to drones/aircraft. A prudent lender may assign little or no collateral value to a drone in parallel to the analysis of residual value of a prudent lessor. Accordingly, lenders should consider structuring loans initially with strong customer credits whenever feasible. Substantial down payments and other credit support such as requiring a creditworthy guarantor to provide a payment and performance guaranty ease the approval and closing of a drone lending transaction.

Hybrid: Bundled Transactions; Leasing Drones and Financing Services

Commercial drone users will, at a minimum, demand the right equipment, software, maintenance and other services when acquiring a drone from a third-party service/equipment provider. For example, a drone provider may offer maintenance, training, software and pilots to their customers. Consequently, drones, like other technology equipment, software and services, should be suitable for leasing through Bundled Solutions Financing (“BSF”) subject to applicable FARs and other laws, rules and regulations covering drones.

According to a study commissioned by the Equipment Leasing and Finance Foundation, ” ' BSF ' entails the financing of equipment along with associated soft costs (e.g., services provided by a lessor or third-party vendor), with the lessor arranging a single transaction that provides an all-encompassing business solution. In the technology marketplace specifically[,] bundling has come to denote an offering that combines the financing of equipment ' such as on-premises servers ' with 'soft' components including software, installation, maintenance, and managed and professional services' .” Captive Bundled Solutions ' Equipment Financing Without the Equipment?, Accenture (Sept. 2009). See http://tinyurl.com/zdfgcdu.

If the services contracts are properly structured, a lessor can either combine or bundle them (i.e., soft costs) with drone equipment leasing. Although lessors and lessees may resist separating the lease from the related service contract, as often occurs, FAA regulatory requirements may modify the analysis from bundled leases of other non-aircraft technology equipment. For example, as an aircraft, filing a security agreement at the FAA is required to perfect a security interest in a drone (i.e., aircraft). Further, the lease of an aircraft is delivered to the FAA to comply with the “truth in leasing” requirements under 14 C.F.R. ' 91.23. It is not clear if or when this separation is required for FAA filing purposes, but the question should be addressed before placing a bundled lease on the public record for all to see.

The basic ideas of bundling transactions, “one throat to choke” and one payment for everything, still survive. Arguably, the structure creates a positive outcome from a legal point of view in these deals because the lessor may achieve clearer “lease” treatment under Article 2A of the UCC through the use of a lease agreement for the drone that does not blend services into the basic structure. Correlatively, the lessee may enjoy greater transparency of service costs through the use of a companion drone service contract.

Vendor Financing

According to the Equipment Leasing and Finance Association (“ELFA”), “[t]here are numerous reasons equipment manufacturers and vendors offer financing to support the sale of their products. Equipment manufacturers and vendors offer financing for their equipment to increase sales revenue, gain market share and improve their customer relationships.” See http://tinyurl.com/zby8f2u.

A drone vendor/fabricator/manufacturer can provide financing to customers directly (“on book”) or as an intermediary between financiers and the end-user. For example, Yamaha Motor Corporation has developed a 200-pound unmanned helicopter for agricultural spraying operations. Due to its credit and commercial quality, Yamaha is a potential model of the type of manufacturer that could implement a vendor program for it drones

The presence of a significant manufacturer, like Yamaha, can increase the likelihood of repayment and proper servicing of drones. For the vendor/fabricator/manufacturer, the opportunity to preserve capital, supply high margin services, increase sales and build a customer relationship clearly fits the business model of other vendor programs today. The attributes tend to attract financiers.

Common Issues in Financing and Operating Drones

Risk-Management Insurance

As financiers consider whether to provide loans and leases for drones, they may understandably fear the risk of drones causing property damage or personal injury. For example, the FAA has recorded many events such as a drone falling from the sky and nearly injuring someone on the ground, or diverting commercial aircraft in flight to avoid a potential collision with a drone. See http://tinyurl.com/hxzx35a.

Insurance is critically important to manage risk and is becoming more readily available for commercial-use drones. See http://tinyurl.com/qa5spww; see also http://tinyurl.com/zka6qy4. Customers and financiers should obtain expert advice on insurance policy coverage including the best available type, underwriter, scope, amount, conditions and exclusions regarding coverages described below.

Standard property and comprehensive general liability insurance may cover certain aspects of drone use, but no one should assume that is the case. Risk managers and insurance experts or underwriters should evaluate the various types of commercial drone use (e.g., crop spraying versus metropolitan package delivery) when considering insurance needs. Generally, financiers, drone operators and their customers should specifically request endorsements, analyze and delete exclusions, evaluate risk attendant to the intended use and obtain policies, if possible, for, among other risks: 1) casualty losses of drones (i.e., lost or destroyed equipment); 2) liability coverage for negligence and third party claims; 3) product liability insurance to protect manufacturers or fabricators of drones and drone components; 4) business interruption of drone provider operations resulting from regulatory or other disruption of operations; 5) premises liability for losses of drones or other property at a particular site; 6) professional and errors and omissions coverage for questionable board decisions or piloting with respect to drone programs and operations; 7) trespass coverage for misguided drones; 8) nuisance for noise and interference with quite enjoyment of property of innocent persons; and 9) invasion of privacy for drone use in non-public or other no-fly areas in the broadest sense under applicable law.

Risk management also extends to technology risk. The two most significant concerns relate to DAA, “detect and avoidance” systems to prevent collisions with manned aircraft and defensive programs to counter hacking into flight control software. See Technological Hurdles Must be Cleared Before Potential of UAS Can be Realized, NBAA, Business Aviation Insider at 15 (Jan./Feb. 2016).

Business operators can mitigate risk through the development of, and adherence to, a commercial drone use policy. The policy should express the operator's business purposes and establish procedures designed to assure safe operations, protect privacy and comply with applicable laws and regulations.

As the complexity of commercial drone use becomes more evident, operators and financiers should consult with lawyers and other experts to remain current on drone use laws and regulations, best practices and technological progress. Businesses should share their policies and procedures with financiers to demonstrate that financing drones have not or will not subject the financiers to unacceptable risk.

Proper Filing at FAA, Registration at IR and Filing Under UCC

All parties should closely scrutinize the rules, statutes, laws and regulations of the FAA (including the FARs), the International Registry (created by the Cape Town Convention 2001, “IR”) and the UCC with respect to each type of drone being financed.

Like other aircraft financing transactions, the parties should make appropriate filings for recordation at the FAA where applicable to the type of drone (noted above). The IR currently does not support the registration of interests in drones under the Aircraft Protocol to the Cape to Convention 2001 or otherwise. That is unlikely to change in the foreseeable future.

A drone and certain embedded software constitute a type of “good” under the UCC (with exceptions). More specifically, each drone should be considered equipment (with exceptions) in which perfection typically (but not always) occurs by filing in the correct location of the debtor.

State Property, Sales and Use Taxes

As in any sale, lease or loan, the parties must pay close attention to sales or use taxes, particularly because most states will, absent an exemption, treat any transfer, rental, lease or sale of a drone as being subject to sales or use taxes. In a traditional aircraft sale, a “fly-away” or resale exemption may be available, but applicable statutes should be closely read as they may not apply to drones as aircraft.

Where a BSF transaction occurs, the service contract portion, if separated from the lease, may be exempt from sales taxes. States have different sales and use tax statutes that apply to equipment though it is important to check whether a particular state has promulgated statutes that cover drones.

A drone used in commercial/business applications presents interesting property tax questions. At the core of property taxes, the assessment of value of commercial use drones may require knowledge and data not yet developed by, or available to, tax assessors. The timing of delivery and location of the business use drone can also affect the liability for, and amount of, property taxes. Accordingly, each drone owner or lessee should examine applicable state statutes and prepare to demonstrate the lowest valuation if not assessed very close to the purchase date when the invoices will likely be used to determine assessed value.

Accounting Under New FASB Off-Balance Sheet Leasing Guidance

The ELFA recently produced a “white paper” on impending changes in the lease accounting rules. The changes will generally require all lessees to put their lease obligations on their balance sheets.

The ELFA paper states that if the “lease contract duration is equal to or less than 12 months, the off-balance-sheet approach currently used for operating leases continues to apply. If the contract qualifies as a service (check definition addressing control and specified asset), the contract does not have to be recognized on the balance sheet.” See http://bit.ly/1oxeS9y. By structuring leases of commercial use drones for less than 12 months, which should be feasible in many cases, these balance sheet reporting exceptions may apply.

Compliance with the FARs And State Law

As discussed in more detail above, the parties must adhere to applicable aviation law, including the FARs, pertaining to, among other things, drone operations, leasing, registration and ownership. Remembering that a drone is an aircraft, the FAA has jurisdiction to enforce the regulations that specifically relate to, among other things, drone “operational control,” certification (if any) of pilots, ' 333 Exemptions and aircraft “operations.” Many states and local governments have considered, and some of them have adopted, rules or ordinances that regulate drone use. These authorities can potentially impose civil and criminal penalties, including fines (e.g., Texas Government Code, Section 423.002(a)), on offenders, in addition to FAA enforcement actions).

Bankruptcy and Creditors' Rights

Financiers almost universally consider the “3Cs” of credit (ratings and capacity to pay), character (of management) and capital (supporting equity) as the crucial factors when analyzing, approving and entering into equipment leases or loan arrangements. Despite applying the 3Cs to approve a drone financing, credit risk and bankruptcy are real concerns for financiers, especially because residual/collateral value provide little, if any, value in a default.

If a drone provider or other operator files for bankruptcy proceedings, a wide range of problems will likely arise that extend beyond the scope of this article. However, the parties should expect to encounter issues regarding the bankruptcy “stay” and lifting it, characterization of bundled transactions (i.e., where leasing and services merge), valuation of a drone in any plan of reorganization and determination of whether a purported lease transaction results in a true lease or a secured financing with completely different treatment in bankruptcy.

Conclusion

Drones have landed in many business markets around the globe and will almost certainly become routine business tools in the years ahead. Even though most drones operated for commercial purposes carry a relatively low price tag, individually ranging approximately from $2,000 to $140,000, specialized financiers can, and many already do, offer leasing and loan products to drone owners and operators. Master lease structures can provide leasing solutions for large and diverse fleets of drones just as other single source leases and vendor programs provide capital in the emerging drone industry.

Institutional financiers may veer away from commercial drone financing or leasing, but the potential for financing through leases, loans, bundled lease and vendor program transactions portend an interesting future for those financiers and customers that participate in the market now and learn the ropes before drone transactions become more common through offerings of current and innovative financing products.

This article has touched on the credit, business, regulatory, accounting, tax, risk management, security, bankruptcy, transactional and other legal aspects of drone financing. We conclude that, although caution is merited when financing or leasing drones, neither customers nor financiers should sit on the bench and watch this exciting new game being played without them.

David G. Mayer is a partner at the Dallas-based law firm of Shackelford, Bowen, McKinley & Norton, LLP. He primarily represents customers and financiers in private aircraft and other equipment transactions, including buying, selling, leasing, lending and operating of aircraft. Contact him at [email protected] or 214-780-1306.

'

SPECIAL OFFER: Twitter, LinkedIn, Facebook and Google+ followers can get an online subscription to Equipment Leasing Newsletter for only $299. Click here, select Digital Only and use promo code ELNOL299 at checkout. This offer is valid for new subscribers only.

'