This presentation aims to discuss the: - business models used by airlines today; - international regulatory framework governing airlines; and - relevance of the regulatory framework to emerging business models

1. SMU DEDMAN SCHOOL OF LAW
AVIATION LAW
INTERNATIONAL REGULATORY
ISSUES IN AVIATION
J. Otto Grunow
Associate General Counsel
American Airlines
November 8, 2007

2. OVERVIEW
• What are the business models used by airlines today?
• What is the international regulatory framework governing
airlines?
• What is the relevance of the regulatory framework to
emerging business models?

3. COMPETING BUSINESS
MODELS
• “Hub and spoke” airlines
• “Point to point” airlines

4. Scenario A
“Point to Point”
Bermuda
New Orleans
Caracas
Bogota

5. Scenario B
Hub With 2 Flights
Bermuda
Miami
New Orleans
Caracas
Bogota

6. Scenario B
Hub With 2 Flights
%
Scenario A Scenario B CHANGE
Markets Served 2 8 300%
Passengers in Markets
Served 3 662 25914%
Aircraft Miles 3533 4580 30%
Ground Crews 4 6 50%
Air Crews & Aircraft 2 2 0%

7. Hub Scenario B
• Combining passengers from different origin cities to a
common destination increases revenue
• Requiring an aircraft to stop at a hub (instead of going
nonstop as the crow flies) only increases costs relatively
modestly (more fuel, more ground crews)
> in reality, instead of one aircraft flying through the hub,
use optimal mix of small and large aircraft transferring
passengers at the hub

8. Hub Dynamics
2600 Markets Served
2400
2200
2000
1800
1600
1400
1200
1000
800
600 Ground Crews,
400 Air Crews & Aircraft
200
0
0 5 10 15 20 25 30 35 40 45 50
Number of Flights in Complex

9. Point to Point Scenario
• Focus only on markets that have sufficient demand relative to
aircraft capacity
• Simplified fleet: one type of aircraft; less training; eases
maintenance, etc.
• No frills service
• Extreme focus on cost control
• Result: even with lower ticket prices, unit revenue should
exceed unit costs

10. INTERNATIONAL NETWORKS
• Traffic aggregation power of a hub and spoke system is well suited to
international service
• Low cost “point-to-point” airlines have not yet fully demonstrated the
ability to serve international markets
– Aircraft type, range and seat density
– Product complexity
• But hub and spoke networks have greater challenges to overcome in
the rigid international regulatory environment

11. INTERNATIONAL REGULATORY
FRAMEWORK
• Unlike international freedom of the seas, there is no
general “freedom of the air”
• Chicago Convention of 1944 established the framework
for economic regulation of international aviation
– Also created the International Civil Aviation
Organization (ICAO) to address technical issues,
safety, navigation, etc.
• A multilateral approach to air transportation favored by the
U.S. was rejected in favor of a bilateral approach favored
by the Europeans
• The Bermuda conference of 1946 produced a bilateral
agreement between the U.S. and U.K., and served as a
model for many agreements to come

12. CONTENTS OF BILATERAL
AGREEMENTS
• A patch quilt of bilateral aviation agreements restricts the
number of carriers that can serve a particular market
– Capacity restrictions
– Limited routes
– Pricing
– Limits on foreign ownership and control and cabotage
– Nationality clauses
• U.S. bilateral agreements are executive agreements, not
treaties

13. CONTENTS OF BILATERAL
AGREEMENTS
• Bilateral framework created the need for quasi-judicial
proceedings between air carriers competing for limited
traffic rights and opportunities
– Administered initially by the Civil Aeronautics Board,
and now by the U.S. Department of Transportation
– Resulted in issuance of certificates of “public
convenience and necessity” authorizing service on
specific routes
– Emergence of national “flag” carriers to exercise
bilaterally-obtained rights

14. U.S. REGULATORY
INITIATIVES
• Buoyed by deregulation of the domestic airline industry
which started in 1978, the U.S. started pressing for less
restrictive and more flexible international bilateral
agreements
• The United States has since signed approximately 60
“open skies” agreements worldwide
• U.S.-E.U. break through agreement signed in 2007

15. TRAFFIC AND NATIONALITY
RESTRICTIONS
• But even “open skies” agreements are not truly open
• Two levels of economic regulation embedded in all
bilateral agreements
– “Freedoms of the air”, dating back to the Chicago
Convention of 1944, define what specific markets can
be served
– Nationality clauses only permit airlines “substantially
owned and effectively controlled” by the country in
question, or its nationals, to exercise traffic rights

16. FREEDOMS OF THE AIR

17. First Freedom
Nation Nation
A B
The right to fly over another country without landing.

18. Second Freedom
Nation Nation
A B
The right to make a technical landing without
picking up or letting off revenue traffic.

19. Third Freedom
Nation Nation
A B
The right to carry revenue traffic from Nation A to Nation B.

20. Fourth Freedom
Nation Nation
A B
The right to carry revenue traffic from Nation B to Nation A.

21. Fifth Freedom
Nation Nation Nation Nation
A B C D
Third Freedom Fifth Freedom Fifth Freedom
The right to pick up or let off revenue traffic between two
foreign nations.

22. Sixth Freedom
Nation Nation Nation
B A C
The right to carry traffic between Nations B and C via the
homeland of the airline, Nation A, is not recognized by the
Chicago Convention.

23. Seventh Freedom
Nation Nation Nation
A B C
The right to carry traffic moving wholly between Nations B and
C, not to, from, or via the homeland of the airline, Nation A,
is not recognized by the Chicago Convention.

24. Eighth Freedom
Nation Nation Nation Nation
B B B B
The eighth freedom or cabotage, is the right to pick up
or let off revenue traffic between points within a nation that is
not the homeland of the airline. Not recognized in the
Chicago Convention.

25. RELEVANCE OF BILATERAL
AGREEMENTS TO HUB STRUCTURE
• Recall the need to combine passengers from many
different origin points traveling to a common destination
> some traveling from a spoke city to the hub
> others originating at the hub going to a spoke city
> others going from one spoke city to another spoke city
through the hub

26. BILATERAL AGREEMENTS / HUB
STRUCTURE
• When the spoke cities and hubs are located in different countries,
complexity quickly arises
• A given plane load of passengers is often governed by a myriad
of bilateral agreements with passengers authorized by different
freedoms of the air
• For example, on an AA flight from Miami to Buenos Aires and
then on to Montevideo there are passengers in the following
categories
• Originating in the U.S. bound for Argentina (3rd freedom under
the US/Argentina Agreement)
Miami Buenos
Montevideo
Aires

27. BILATERAL AGREEMENTS / HUB
STRUCTURE (cont.)
– Originating in the U.S. and bound for Uruguay (3rd freedom
under the U.S.-Uruguay Agreement)
Miami Buenos Montevideo
Aires
– Originating in Spain and bound for Argentina (6th freedom
under the U.S.-Argentina Agreement)
Buenos
Spain Miami Montevideo
Aires

28. BILATERAL AGREEMENTS / HUB
STRUCTURE (cont.)
– Originating in Buenos Aires and bound for Uruguay
(5th freedom under the U.S.-Argentina Agreement and
under the U.S.-Uruguay Agreement)
Miami Buenos Montevideo
Aires

29. BILATERAL AGREEMENTS / HUB
STRUCTURE (cont.)
• If traffic rights not available or available in sub-optimal
mix, hub-type economics unravel
– not enough seats / frequency
– not enough markets to feed sufficient passengers,
particularly from the foreign end
– inefficient use of aircraft (long lay-overs)

30. STRATEGIES FOR COPING WITH
REGULATORY RESTRICTIONS
• Imagine the power of a “double hub” structure to serve an
exponentially greater number of “city-pair” markets
U.S. Spoke Spoke Cities
Cities Europe
Canada Spoke Chicago London Spoke Cities
Cities Middle East
Other Spoke Spoke Cities
Cities Africa
• Could create 40,000 or more city pair combinations

31. FOREIGN OWNERSHIP AND
CONTROL
• If a U.S. airline does not have sufficient traffic rights
beyond London, why not buy a U.K. airline or vice versa?
• 25% voting equity limit on foreign ownership of U.S.
airlines (49 U.S.C. 40102(a)(2) and 2(15))
• 49% non-voting equity interest permitted if no de facto
foreign control
• Similar (49%) ownership restrictions in Europe

32. FOREIGN OWNERSHIP AND
CONTROL (cont.)
• If a U.S. airline cannot fly beyond London to spokes in
foreign countries, why not at least gather passengers by
flying aircraft to points within the U.K.
– Cabotage restrictions almost universal
– In the U.S. 49 U.S.C. 41703: foreign airlines may not
carry revenue passengers between points within the
U.S.

33. STRATEGIES FOR COPING WITH
REGULATORY RESTRICTIONS
• International airlines seek network breadth and depth
through
– Codesharing to garner “feed” traffic
– Joint ventures
– True mergers
– Alliance branding
– Locally “controlled” subsidiaries

34. CODESHARING
• Holding out of air transportation for sale using a flight
designator code (“AA” for American Airlines, “BA” for
British Airways, etc.) to simulate on-line connections
• Codesharing as a form of sub-contracting by the
“marketing” carrier to the “operating” carrier
• Regulators require the marketing carrier to hold traffic
rights under the bilateral agreements

35. MULTILATERAL ALLIANCES
• oneworld, Star, Sky Team Alliances
• Multilateral combination of codesharing, frequent flyer
reward program reciprocity, and harmonization of other
customer service features
• Antitrust immunity

36. MULTILATERAL ALLIANCES
(cont.)
oneworld Star Sky Team
American Airlines Air Canada Aeroflot
British Airways Air New Zealand AeroMexico
Cathay Pacific ANA Air France
Finnair Asiana Airlines KLM
Iberia Austrian Alitalia
Japan Airlines (JAL) bmi Continental Airlines
LAN LOT Polish Airlines Czech Airlines
Malév Lufthansa Delta Air Lines
Qantas Scandinavian Airlines Korean Air
Royal Jordanian Singapore Airlines Northwest Airlines
South African Airways
Spanair
SWISS
TAP Portugal
THAI
United
US Airways

37. ANTITRUST IMMUNITY
• To increase economies of scope and scale, and maximize traffic rights,
airlines have created joint ventures as a substitute for true mergers
– U.S. Department of Transportation has power under to grant
antirust immunity
– Bestows ability to act as a single enterprise collaborating on
marketing activities and sharing revenue and profits
• STAR carriers have been granted broad multilateral immunity
• The SkyTeam carriers have re-applied for similar multilateral
immunity
• oneworld Alliance historically limited by “closed” skies

38. U.S-E.U. DEVELOPMENTS
• Moving away from “freedoms of the air” and statutory
limitations on foreign ownership and control
• This follows a European Court of Justice decision
declaring nationality clauses in the U.S. Bilateral
Agreements with various European countries unlawful
– Violates a European “right of establishment”: e.g. a
Greek carrier must have the right to set up shop and
exercise traffic rights from France

39. U.S.-EU OPEN SKIES
• After nearly five years of negotiations, the U.S. and EU
agreed to a first stage “Open Skies” agreement in March
2007
– The agreement will take effect March 2008
• Under the terms of the agreement, EU carriers will be able
to operate from any city in the EU to any city in the U.S.
and vice versa
– In traditional bilateral terms, these are seventh
freedoms

40. U.S.-EU OPEN SKIES (cont.)
• Most important is the opening of Heathrow airport
– Today only American, United, British Airways and
Virgin Atlantic are permitted to operate in the U.S.-
Heathrow market
• U.S. carriers will launch new services to Heathrow
– Delta, Continental, Northwest and U.S. Airways have
already announced new services
– Incumbents will shift Gatwick services to Heathrow to
respond to increased competition

41. U.S.-EU OPEN SKIES (cont.)
– The agreement does not provide for new landing and
takeoff slots at Heathrow; carriers must find their own
slots and facilities in order to operate Heathrow routes
• Lucrative “gray” market has developed, with
carriers relying on the UK High Court’s decision in
the Guernsey case to legitimate multi-million dollar
slot “swaps”

42. COMPETITION TO
CONTINENTAL EUROPE WILL
ALSO INCREASE
• Virgin Atlantic has announced plans to launch new service
from Paris, Frankfurt, Milan and Zurich initially to New
York, and later to other U.S. destinations
• British Airways has plans to launch a series of new
services from continental Europe to the U.S. in the
summer of 2008
• Relaxation of bilateral constraints in U.K., Spain, Ireland
and other EU countries will facilitate antitrust immunized
Alliances

43. POINT-TO-POINT
INTERNATIONAL SERVICE
• Emergence of Maxjet, EOS and Silverjet in the U.S.-
London market
– Operating from secondary airports (e.g., Stansted,
Luton)
– Less dependent on connecting passengers and hub
flows
– Premium product focused on locally-originating
business travelers
• Low cost carrier Ryanair is considering service from
Stansted, Dublin and Frankfurt to U.S. points

44. POINT-TO-POINT
INTERNATIONAL SERVICE (cont.)
• Eos Cabin Configuration
• MAXjet Cabin Configuration

45. FUTURE U.S.-E.U.
DEVELOPMENTS
• Second stage negotiations to be completed by 2010 to
address more controversial issues including:
– Further liberalization of traffic rights (cabotage)
– Additional foreign investment opportunities and control
of U.S. carriers

46. CONCLUSION
• International strategy will continue to be driven by two
important principles:
– Hubs will continue to be valuable traffic aggregators
– Network ubiquity is important to customers
• Codesharing and brand alliances enhance the
network and provide a transition strategy
• Ultimately, cross-border M & A will help
international airlines find optimal scope and scale
• Point-to point niche carriers may get stronger