Reforming ownership laws: inevitable and not so radical December 1998

One aspect of today’s airline industry remains firmly rooted in the distant past — aviation is still treated by governments as something ‘special’ when it comes to allowing foreigners to own and control national companies. Most countries — even (especially?) some of those that claim to favour open markets and increased competition — continue to apply old–fashioned rules designed to ensure that airlines remain ‘protected’ from foreign investment.

As EU transport commissioner Neil Kinnock has noted: “Aviation is still not a normal economic activity because the restructuring and consolidation of the airline business continues to be hampered by regulatory barriers inherited from the time before liberalisation.”

Or in the words of Don Carty, chairman and CEO of American: “Airlines have always had a peculiar relationship with the sovereignty of nations. There are no ‘flag’ chemical companies or ‘flag’ hotel companies. But there are ‘flag’ airlines, and individual nations have historically protected those airlines by limiting competition from airlines from other countries and by limiting foreign ownership ... If ours were a normal business, we could grow our overseas presence by simply building our existing network throughout Europe, Asia and Latin America — or by acquiring airlines who had established such networks. But the airline business is somewhat unique.”

In fact, the origins of the current ownership and control restrictions can be traced all the way back to the International Air Transit and International Air Transport Agreements of 1944 and the UK/US Bermuda I Air Services Agreement that followed. Some have argued that what began as a relatively permissive regime, gradually became increasingly restrictive as states adopted a more mercantilist approach to international air transport. Whether this was the case or not, it is certainly true that only relatively recently has persistent pressure emerged to carry out a fundamental reform of the ownership and control rules.

IATA, which established a working group to consider this subject, has suggested five reasons why change is now being pursued:

Privatisation of airlines;
The desire to establish global networks;
Increasing capital requirements;
The desire to cement marketing alliances through equity participation between carriers of different nationalities; and
The development of the notion of community (especially EU) ownership and control.

Whatever the reason, it is evident that the commercial pressure for change is building up and forcing governments to re–examine their traditional positions.

Sub-optimal restructuring

The growth of global alliances is of particular relevance here. The contradiction between an increasingly global business and national ownership rules is evident for all to see. The industry has been forced to restructure itself — for example by creating a series of loose–knit alliances — in a way that is clearly not optimal. In many respects airline alliances represent an artificial response to the artificial problem created by the refusal of governments to permit the type of restructuring that other industries have long since experienced.

As Fred Reid commented when he was president and COO of Lufthansa: “…alliances ... are only an interim answer to the question of how to operate a global aviation network. The best solution, in my view, would be the elimination … of the laws that keep meaningful levels of transnational ownership over the horizon.”

A great deal of attention, of course, has focused on the US market. It has long been an irritant to many countries, not least the UK, that the US should lecture the world about the benefits of competition and open skies whilst maintaining a protected home market. The size and structure of the US domestic market undoubtedly provides substantial benefits for US carriers when competing in international markets. Yet so far the US has refused to contemplate the removal of ownership and cabotage restrictions. Even the modest reform of increasing the proportion of voting shares in US airlines available for foreign ownership, from 25% to the 49% found in most other countries — a reform that is supposed to have the support of the current US Administration — has yet to be introduced.

Why discourage foreign ownership?

Those who seek to maintain the current US ownership restrictions focus on two issues in particular: national defence and employment. Neither argument stands up to any serious analysis. As has been widely reported, Virgin is keenly interested in establishing a US airline. Richard Branson has given a commitment that in the event of a national emergency, “Virgin America” aircraft would be put at the disposal of the Pentagon. Similarly virtually all staff, and quite possibly all aircraft as well, would be American. Given such a commitment, what exactly is the problem supposed to be? What are the opponents trying to protect?

On the other hand, the benefits of increased foreign investment could be substantial. Criticism of the lack of real competition within the US domestic market has grown markedly in recent years. Fares on many routes have increased, whilst service quality has declined. Co–operation rather than competition has become the industry’s driving force, with a possibility that the US market could soon be dominated by just three mammoth domestic alliances. Alfred Kahn points out that there is a technical term to describe all this: “It’s called chutzpah!”

There is ample evidence of a need for new entrants to challenge the positions of the dominant carriers, particularly new entrants with access to considerable financial resources, and the ability and willingness to stand up to bullying tactics by the Majors. The reality is that the “main hope,” to quote Kahn again, for introducing more competition to the US market lies outside the US. The levels of financial and managerial resources needed are unlikely to be found in sufficient quantity if the US continues to maintain its current protectionist barriers. Politicians such as John McCain, chairman of the Senate Commerce Committee, realise this and are lending their support to a change in the law.

A measure of how different aviation still is, is that it is almost the only industry where foreign investment is positively discouraged. If a foreign car manufacturer announces its intention to build a plant in the US it is invariably overwhelmed with requests from politicians and businessmen to site the plant in their cities. Virgin faces no significant legal barriers to opening Megastores in the US, any more than Tower Records does to establishing branches in the UK. Open markets benefit consumers, and benefit the industries themselves by ensuring they remain competitive. But not apparently in aviation — at least not so far.

The US has an excellent opportunity to reform its airline ownership and control rules. It is desperate to get rid of the Bermuda II air services agreement with the UK and gain access to Heathrow for all US carriers. Its strategy of doing this by holding out the prospect of antitrust immunity for the BA/AA alliance is clearly not working. In any case, such a strategy is wrong in principle. Anti–trust immunity for airline alliances should not be used as a bargaining tool in international negotiations. It should be granted only when the regulatory authorities are satisfied that an alliance will produce net benefits for consumers.

The US approach has allowed the UK to take the moral highground. Rather than rolling over and gratefully accepting the US version of open skies, as the US appeared to have expected, the UK is quite rightly insisting that if competition is to mean anything, UK carriers must have effective access to the US domestic market. Changes to the ownership and control rules are an integral part of this strategy. Fred Reid has argued that “open skies without ownership liberalisation is unsustainable in the long–term”. The question is: for how long can the US sustain its protectionist international aviation policy?

The US pleads that this is all too difficult and time–consuming, requiring changes to US law over which the Administration does not have full control. In fact, the suspicion must be that the US does not see the need to be more radical. This could well be a mistake. Even if the end result of the UK negotiations is the maintenance of Bermuda II, or only modest reform, the European Commission will be next in line with the same demands. The pressure for reform is not likely to lessen.

Within the EU ownership and control rules have already been reformed. There are no restrictions on individuals or companies of one member state buying or establishing an airline in another member state, or on an EU airline operating anywhere within the Community (apart from a few minor exclusions). The result has certainly been an increase in competition. However, the EU continues to restrict investment in its airlines from non–EU sources, and even within the EU foreign ownership and control can still be a problem when a carrier seeks to operate to a non–EU country.

Neil Kinnock claims to have “spent many hours in the last three years trying to explain to my colleagues in the member states that these nationality clauses are not only legally inconsistent with the freedoms of the common market, but that they are also economically harmful because they preserve the fragmentation of the internal market and prevent a sound and efficient restructuring of the European aviation industry … The rational course that should be taken is plain. But old habits die hard.”

Some countries in Europe, notably the UK, have gone further than required under European law. The UK’s model bilateral agreement already refers to an airline’s ‘principal place of business’ rather than the proportion of its shares owned by nationals. (The concept of ‘principal place of business’ exists already in both Chicago and EU legislation, although it is not precisely defined.) Several countries have agreed to the UK text. UK carriers such as Britannia and Monarch have been 100% owned by non–UK (and non–EU) nationals for many years, yet still regarded as UK and EU airlines. They are based in the UK, they operate under UK regulatory supervision, they employ UK staff, etc. Can anyone really say that for all intents and purposes they are not UK companies, apart from the fact that their ultimate owners happen to be Canadian or Swiss? They are only remarkable because the airline industry continues to be treated differently from most other businesses.

Lots of precedents

In fact, the UK is far from unique in Europe in seeking to reform the outdated ownership and control rules. A recent task force on this subject established by ECAC revealed that the Netherlands, Switzerland, Sweden, Norway, Denmark, Finland, Germany and Italy are all pursuing a similar policy with bilateral partners outside the EU, and each has had at least some success. Similarly, the ICAO Air Transport Regulation Panel has recommended that the traditional controls on ownership and control should be replaced by the concept of a “strong link” between an airline and the state which is designating it.

Outside Europe change is also evident. New Zealand long ago allowed one of its airlines to be owned by an Australian company, and Air New Zealand now exerts considerable control over Ansett of Australia. Foreigners have had control over Aerolineas Argentinas, Aero Peru and, until its demise, Viasa. Peru’s Congress recently even passed a law allowing foreign airlines to operate domestic routes, following widespread complaints from consumers and tourism interests about delayed and cancelled flights by local carriers. Similar examples are to be found elsewhere, and of course Air Afrique, Gulf Air and SAS are long–standing examples of pan–national airlines for which an exception to the ownership and control rules has been made. The trend is clearly towards more, genuinely open markets.

Even the US has shown flexibility when it was in its interest to do so. The cases of Iberia’s control over Aerolineas Argentinas and, in a different context, KLM’s investment in Northwest indicated that rules can be re–interpreted, at least up to a point. In Europe, the Swissair investment in Sabena pushed the EU ownership and control rules to the limit, and some would say beyond the limit.

The real concerns

The traditional reasons to resist reform, especially those based on national security and employment arguments, may not stand up to analysis, but there are nevertheless genuine reasons for states to be at least cautious. In particular, concern continues to be expressed about possible safety implications if airlines are no longer tied so closely to their ‘home’ countries. No–one wants to see the concept of ‘flags of convenience’ spreading from shipping to aviation.

In fact, the evidence suggests that the risk is minimal. Those countries that have replaced the traditional ownership restriction with a ‘principal place of business’ requirement have also insisted that an airline must have an Air Operator’s Certificate from the state designating it. This should be sufficient to prevent carriers from transferring responsibility for their safety supervision to countries unable or unwilling to carry out their duties effectively.

Even the International Transport Federation, representing trade unions with members employed in transport, which campaigns ceaselessly against flags of convenience, has acknowledged that this safeguard “would certainly appear to go a long way” to solving the problem, although it cautions that entrepreneurs’ capacity to find a loophole in the rules should not be underestimated. Insisting on an AOC issued by the designating state will not guarantee that every airline is supervised properly for safety purposes (witness the problems encountered with several countries’ regulatory regimes under current circumstances), but there is no reason at all to expect any deterioration.

A more justified criticism of the approach adopted by countries such as the UK is that it will not actually permit full global mergers. For example, suppose KLM, Northwest and Alitalia merged completely to create a single company. Where would its ‘principal place of business’ be situated? In Detroit, Amsterdam or Milan, or all three? The problems associated with formal designation are obvious.

The ICAO Air Transport Regulation Panel has suggested that in assessing an airline’s principal place of business a state should take into account whether the carrier has a substantial amount of its operations and capital investment in physical facilities in the designating country, pays income tax and registers its aircraft there, and employs a significant number of nationals in managerial, technical and operational positions. It has been suggested that, with the degree of regulatory flexibility of which states are certainly capable, these criteria could be met by changing ‘the principal place of business’ to ‘a principal place of business’, although it is not obvious that such a change would do justice to the English language.

In any event, even if reform is possible only on a bilateral basis, that reform is still well worth pursuing. It will produce substantial benefits in its own right. And once the concept of cross–border ownership has been accepted by a significant number of states, the step from a bilateral to a multilateral approach, which would certainly permit global mergers, will be all the easier. The probability must be that resistance to including the ownership and control of airlines in the General Agreement on Trade in Services (GATS), with its fundamental Most Favoured Nation principle, would soon evaporate. (Such an approach might initially focus on air cargo, as Frederik Sorensen of the EC has suggested. Air transport participation in GATS is scheduled to be reviewed in 2000.) Then at last air transport would be treated like any other mature industry.

Unstoppable momentum

The idea of reforming the traditional approach to airline ownership and control rules might appear superficially to be a radical step, and indeed it is in terms of the potential effect it will have on the industry, but the reality is that in large parts of the world a clear momentum is building up. That momentum reflects above all the commercial priorities of the major airlines, which individual states are unable to resist — even if they wanted to. Even the US will find it difficult to maintain its current protectionist policies in the context of such worldwide pressure, quite apart from the internal pressure it is facing to introduce more domestic competition.

Global airline alliances may be the future for the industry, but it does not follow that the current alliances bear more than a passing resemblance to the ones that will emerge when the ownership and control rules are reformed. The criteria used to pick a partner for a loose alliance will be very different from those applied when deciding to purchase another carrier or merge fully with it. The structure of the airline industry is still a long way from being finalised.