There seems to be a growing consensus in the airline industry that the rules restricting the foreign ownership and control of airlines are archaic and should be significantly liberalised or abolished. However, a majority of delegates at the CAPA Airline Leader Summit in Dublin of 11-May-2017 did not expect the rules to be discarded any time soon.
Removal of the restrictions would allow meaningful cross border mergers and acquisitions on a global basis and lead to significant benefits to the airline industry's economic performance. There has been change in this area and some significant examples of government relaxation, or waiving of the rules.
Nevertheless, the rules, which originate in the Chicago Convention of 1944, have proved to be notoriously durable over many decades. Currently, most of the change is coming from efforts exerted by airlines to find new ways to circumvent the rules on ownership and control. This simultaneously illustrates both the increasing irrelevance of the rules and their enduring stickiness.
There are two elements to ownership and control rules
As their name suggests, ownership and control (O&C) restrictions have two elements.
The first, which is easier to define and monitor, involves placing explicit numerical limits on foreign nationals' ownership of the voting equity share capital of airlines. As examples, the US places a limit of 25% on foreign ownership of its airlines; for Japanese airlines the limit is 33%; and the European Union limits non EU ownership of the airlines of its member states to 49%.
The second element of O&C restrictions stems from the nationality clauses present in the bilateral air services agreements between states. In essence, the traffic rights granted under these bilaterals require that airlines benefiting from these rights are substantially owned and effectively controlled by nationals of the state in question.
Ownership is relatively easy to establish, but effective control is more blurred. It is not always possible to express numerically the level of influence that an investor has in the management of an airline in which the former has invested. Of course, factors such as entitlement to appoint directors are taken into account, but this is not always clear cut.
What is clear is that the industry has increasingly found ways to circumvent O&C rules. Moreover, governments in a number of regions have lowered the restrictions.
Governments have made some changes to O&C
Government action to dilute or otherwise lower O&C restrictions has taken a numbers of forms.
As a replacement for imposing strict limits on foreign ownership or board membership, there has been some progress towards requiring airlines only to have their principal place of business in the state that is granting traffic rights.
The adoption of this approach in Latin America (specifically Chile, Costa Rica and El Salvador and in an increasingly liberal stance by Brazil) helped to facilitate the formation of LATAM through the merger of LAN and TAM.
However, attempts by the Qantas subsidiary Jetstar to establish a minority owned affiliate in Hong Kong, as it has done elsewhere, were rejected in 2015 when the regulator broadened the definition of principal place of business to include the likely influence of its foreign parent company in Australia.
In Australia there is no foreign ownership limit on airlines operating only in the domestic market, although there is a 49% limit on airlines flying international routes.
India has progressively relaxed its rules from banning foreign airlines taking any stake in Indian airlines, to allowing a 49% stake (in line with non airline foreign investors) to, most recently, allowing 100% foreign ownership of domestic carriers.
In the specific example of the European Union and the European Common Aviation Area, O&C rules have been abolished entirely for airline operations within the European single market. The ASEAN bloc (Association of Southeast Asian Nations) has also taken some steps towards liberalisation. On paper, at least, ASEAN intends to move to a fully liberalised EU style single aviation market, although progress is slow.
O&C rules are often overlooked, or are liberally interpreted
There are also examples of the selective ignoring of nationality clauses in air services agreements, although this tends to be only if it is in the interests – or at least not actively against the interests – of the nation choosing to waive the restrictions.
However, this approach is unreliable, is subject to abuse, and does not allow a long term planning horizon for airlines.
There are certainly examples where the requirement for effective control to be in the hands of nationals from the same state as the designated airline has been overlooked or interpreted in a particularly liberal manner.
Delta Air Lines of the US owns 49% of the equity of Virgin Atlantic of the UK. This ensures that it does not contravene the EU's 49% limit on foreign ownership. However, effective control is not so straightforward.
The biggest part of Virgin Atlantic's operation is on routes between the UK and the US. According to data from OAG, routes to the US account for 72.5% of Virgin Atlantic's seats in the week of 15-May-2017, while its 2016 accounts show that routes to North America were the source of 66% of its scheduled revenue last year.
Its US routes are operated in a 50/50 joint venture with Delta, which means that Delta has effective control over the JV (Delta's interest in the JV is almost 75%, consisting of its own direct 50% and its 49% of Virgin's 50%).
Delta's effective control of the JV gives it effective control over Virgin Atlantic's biggest business segment and, in the eyes of many observers, it effectively controls Virgin Atlantic as a result. Yet the European Commission approved Delta's stake in Virgin, and not one government has raised any objection to the control arrangements.
Virgin Atlantic Airways: seats by destination country week of 15-May-2017
Other examples include Etihad's minority equity stakes in a number of airlines, some of which have been examined by the European Commission. These include its 49% stake in Air Serbia; its 33.3% stake in the Swiss carrier Darwin Airline (rebranded as Etihad Regional Airlines); its 29% stake in airberlin; and its 49% stake in Alitalia.
Although demonstrably minority voting stakes, these Etihad investments go further than the typical equity participation, with their talk of cost synergies, close commercial cooperation and the appointment of senior executives by Etihad. Etihad also contributed to, and approved, new business plans.
Moreover, particularly in the case of airberlin and Alitalia, the weak financial state of the target company meant that they were effectively rescued from collapse by cash from Etihad (in airberlin's case – many times), giving the Abu Dhabi airline a strong hold over the investment airline.
Again, the European Commission approved these stakes by Etihad in European airlines and there have been no objections by governments.
European holding company structures: a self fulfilling prophesy
Slightly more opaque, but creating the perception of respecting O&C rules, are the holding company structures of European groups such as IAG and Air France-KLM. Majority economic ownership is visibly held by the parent company at the top of the respective groups, but each has devised more complex structures to project a kind of legal fiction that purports to keep voting control with nationals of the respective subsidiary airlines.
No doubt, these were constructed by highly experienced and remunerated aviation lawyers and were designed to comply with the rules. However, in a sense they have become a kind of self fulfilling prophesy: they work because they work, and this is because nobody has challenged them.
KLM did not lose its traffic rights to fly to Japan, for example, because the government of Japan accepted KLM's new ownership structure after it was acquired by Air France to form Air France-KLM.
Lufthansa took a more watertight approach when buying Austrian and SWISS
When Lufthansa acquired Austrian Airlines and SWISS, it took a different (and more watertight) approach. It enlisted the support of the Austrian and Swiss governments to secure all the relevant traffic rights from the governments at the other end of the airlines' route networks.
This required those third party nations to waive the nationality clauses in their bilaterals, something that quite a large number of governments agreed to do.
Governments recognise there are benefits to liberalising O&C rules
As described above, there are many examples of ways in which governments are often more than willing to relax O&C rules. This is because liberalisation produces benefits.
They are keen to widen the available pool of investment capital and management talent for their country's airlines. One of the reasons for the historic inability of the airline industry to earn its cost of capital is the fragmented market structure forced upon it by O&C rules.
Without these rules, greater consolidation through cross border mergers and acquisitions would be possible on a global basis, allowing for more efficient use and allocation of capital and capacity, and the elimination of duplicated costs.
The US airline industry, which is predominantly reliant on the domestic market, can be seen as a kind of control experiment that illustrates the benefits to airline profitability from consolidation.
But the rules remain sticky
However, in spite of the benefits of abolishing the restrictions, and the many illustrations of governments and regulators relaxing the O&C regime, the pace of change is slow. The fact is – ownership and control restrictions still exist.
To some extent, the stickiness of O&C reflects the complexity of achieving simultaneous change in a complex global web of bilateral agreements.
As Ulrich Schulte-Strathaus said at the CAPA Airline Leader Summit, "governments need ownership and control rules to negotiate with others". There has been a reluctance by governments to move ahead with unilateral change.
The EU-US 'open skies' agreement of 2007 brought some important changes in that it allowed all EU airlines and all US airlines to fly between any point in the EU and any point in the US. Moreover, at the time it also brought the prospect of meaningful change in ownership restrictions, with both sides agreeing to a second stage, where foreign ownership limit would be equalised at 49% for both.
However, this has not happened, and the EU (already at 49%) has left nothing to push the US up to the same limit. In the past a global leader in the liberalisation of aviation, the EU is now unlikely to make any unilateral move to increase or abolish the foreign ownership limit.
O&C rules are seen as an expression of national sovereignty
For many governments the O&C rules are an expression of national sovereignty, although they are increasingly anomalous in a globalised economy. They often appear as barely disguised protectionism, as illustrated by the protracted struggle forced upon Virgin America in establishing itself as a US airline, even with a minority foreign owner in the form of Sir Richard Branson's Virgin Group.
Of course, governments have a legitimate interest in protecting national sovereignty, but this does not necessarily require foreign ownership limits. Indeed, few other industries are treated in the same way as the airline industry in this respect. Governments can retain control over national aviation policy and regulation, whether individually or through collaboration with other nations, without worrying about who owns the airlines operating in their air space.
The World Economic Forum has proposed a change to O&C rules that would replace a citizenship definition of nationality with a concept of regulatory nationality. This is similar to the idea of principal place of business, but more narrowly defined and therefore less likely to restrain airlines planning subsidiaries in foreign locations.
Regulatory nationality would refer to the state that oversees the airline's compliance with safety, labour and environmental regulations; where the majority of its aircraft are registered, and where it pays taxes. This would separate the nationality of an airline as determined from a regulatory point of view from the nationality of those owning its shares or making operational decisions.
Airlines increasingly circumvent the rules
From the industry's side, airlines have found many ways around the restrictions.
The global alliances and the antitrust immunised joint ventures within them are obvious examples. In the words of Professor Rigas Doganis at the CAPA Airline Leader Summit in Dublin in May-2017, "the ATI JVs make a mockery of ownership rules". They control 80% of North Atlantic capacity, but their nationality cannot be defined. "The nationality issue is irrelevant", said Professor Doganis.
Beyond these commercial tie ups between airlines, equity relationships of the kind already described are a more committed way to circumvent O&C rules. Taking the equity investment approach even further, with common branding and the external perception of a single airline group, are the low cost groupings in Asia.
AirAsia and Jetstar are the two best examples, where the brand's original airline has established new operators under the same brand and overall product in foreign countries with the support of a local investor taking a majority stake on a more passive basis.
A cyclical downturn may be necessary to catalyse more radical change to O&C rules
The increasingly inventive ways devised to work around the O&C rules have led to significant change in the world airline industry landscape, perhaps most interestingly illustrated in recent times by Norwegian's attempts to construct a truly global airline.
However, all of the circumventions that have been adopted have produced produce structures that are economically less efficient than full scale mergers and acquisitions.
Intriguingly, there is not really a concerted lobbying effort from the industry for radical change to the rules. Perhaps some airlines are also mindful of perceived benefits from the protectionist angle.
There is change, but change is seen more in the airlines' ability to find ways around the rules than in government actions to abolish the rules – or even to seek significant liberalisation of the rules.
While the industry is enjoying a period of cyclically high margins and, according to some estimates, actually earning its cost of capital, the more powerful airlines may be content with the current rules.
However, a cyclical downturn could lead to greater pressure for meaningful global consolidation, perhaps sparking further significant pressure and change in the O&C regime.