Introduction:
Airlines were often controlled by their national government despite serving an international market. Airlines have not been taken over by multinational corporations due to restrictions laid down in the Air Service Agreements. The Chicago Convention included the assumption national government's administered their own airlines. Countries often make bilateral agreements which allow their airlines to fly over another nation and use its airport facilities. Some European airlines have made alliances with US airlines in preference to partnerships with each other.

The Chicago Convention of 1994 is inspired by the principle that an airline has a nationality. Agreements on air services are as between national entities. Hence tight regulation and surviving state ownership (or close state solicitude). An international industry par excellence is prevented from developing into multinationalism: and European airlines are unable to consolidate.

Air transport is a deeply paradoxical industry. By its very nature and in its daily operations, it is cosmopolitan and dedicated to making mobility easier: it operates across borders in an element without natural frontiers. But the air transport industry is also notorious for being cloaked in the mantle of nationalism. It is also one of the most tightly-regulated industries, and one in which state ownership is still pervasive -- a remarkable irony in an industry that enables others to escape the limits of national markets and the impositions of national government.

The state's consistent protectiveness toward `its' airlines and its insistence on controlling movements within its own airspace goes back (at least) to 1909, when Henri Bleriot's monoplane landed on the golf course at Dover. His flight (which was not, as subsequently alleged, one of the earliest responses to overbooking) reinforced fears that heavier-than-air aircraft would be a serious threat to national security. To deal with this threat, European states agreed in 1911 that national sovereignty over airspace should be absolute -- a principle that automatically gave states control over movements at airports when commercial aviation developed.
Fears about the use of commercial aircraft for spying and for military purposes led between the wars to national legislation that extended control over airspace to control over the operation of aircraft and the establishment of airlines. Policymakers believed that it was important, for security reasons, to know who actually owned an aircraft and who owned an airline. They also believed that it was important to limit opportunities for foreigners to take control of national airlines (if they were not already state-owned).

States therefore required that aircraft be entered in national registers and that (to obtain registration) they be owned by their citizens (or by organizations controlled by their citizens). Airlines had to obtain operating licenses from national aviation authorities, and for this purpose they had to show that they were `substantially owned and effectively controlled' by individual or corporate citizens.
The 1944 Chicago Convention on International Civil Aviation (which remains the legal basis for regulating international air services) built general rules for the allocation of traffic rights upon existing national regulation grounded in the nationality principle. It gave states the right to authorize services across borders, through individual, bilaterally negotiated Air Service Agreements (ASAs) specifying routes, number of carriers and capacity to be offered. Once an ASA is negotiated, the governments concerned allocate the traffic rights obtained to national carriers -- usually, one carrier per country The resulting duopolies often involved coordinated scheduling and fare-setting and sometimes actual pooling of revenue.
Why airlines are not multinational enterprises:

The Chicago Convention assumed that governments controlled `their' airlines. It attributed nationality to aircraft through the registration process. But it did not assume that airlines had only one nationality (or, indeed, that they were state-owned). Nationality restrictions did, however, appear in a model ASA attached to the Convention: they are still in most of the several thousand bilateral ASAs that shape the map of international aviation. In the model document, the various freedoms of carriage agreed between states are offered subject to the right of a party to cancel the traffic rights of a foreign airline if it is `not satisfied that substantial ownership and effective control are vested in nationals of a contracting State'. The wording was meant to exclude countries and carriers that stood outside the Convention. But it was later changed to refer simply to the signatories of individual ASAs: Brazil, for example, could challenge the rights of, say, Lufthansa if the latter came under non-German ownership. It could still do so.

The `substantial ownership and effective control' clauses -- added to the other restrictions on foreign ownership of aircraft and airlines -- are a major obstacle to the creation of any multinational enterprise in air transport that involves purchase of controlling equity, within as well as outside the EU. Their existence also helps to explain the development of international code sharing alliances between airlines. The development of these alliances, in turn, helps to explain why cooperation between national carriers in the smaller EU member states has stalled, and why the Commission has faced so much opposition in its campaign to take over negotiating authority in aviation from member states.

Multinational enterprises do seem to exist in commercial aviation. But the three cases usually cited -- Air Afrique, Gulf Air and SAS -- are in fact government-sponsored consortia. SAS, for example, was initially a consortium of three national airlines (DDL of Denmark, DNL of Norway and ABA of Sweden,). Though these initials do not appear prominently on SAS aircraft and never in the airline's publicity, the SAS fleet is technically divided between these three airlines and (as the world's plane spotters know) bear national registration marks of one of the three component states. Moreover, since under the established regime only individual states can actually allot traffic rights, the international traffic rights of `SAS' are actually the product of parallel negotiations conducted by the Danish, Norwegian and Swedish governments, though sometimes trading partners have agreed to shared rights (termed a `SAS clause').

One airline can, indeed, buy up another. Within the EU, such equity purchase has already occurred, notably in BA's creation of subsidiaries in France and Germany (with KLM's interest in Air UK -- until it took a 100% stake in the summer of 1997 -- and SAS's interest in British Midland being examples below the 51% level). The EU's definition of a `Community carrier' admittedly excludes majority ownership by non-EU citizens, and similar restrictions still apply elsewhere. But an American airline could, strictly speaking, buy shares in any publicly quoted European airline and might, momentarily, acquire a controlling interest.

Such control would, however, be worthless. In many cases, it would also be blocked by rules adopted by the target carriers to protect their national status. The ownership and control provisions (of which the EU's `Community carrier' category is simply an example applied within enlarged boundaries) mean that the acquired company would cease to be a `national' or `Community' carrier. It would then risk losing international rights acquired under ASAs with states outside the EU. It would also lose its right to an operating license for routes within the EU. In short, the new owner would have acquired an impressive but costly static aircraft display.
The Perils of privatization:

The hypothetical acquisition might not even occur, or it might be reversed afterwards. Several countries have legislation or agreements intended to prevent `denationalization' of their carriers. Much of this legislation is in line with the nationality legislation adopted between the wars and subsequently, requiring national ministries to establish `substantial ownership and effective control' before authorizing operations. But privatization has raised the issue again: airlines that were once state-owned (and therefore invulnerable to takeovers) become vulnerable once their shares are publicly traded.

The Netherlands and Germany have both adopted procedures designed to protect carriers that are moving out of their formal control. In the Dutch case, the level of government shareholding in KLM has fallen from 95% (between 1945 and 1956) to 38.2%, with suggestions that a further reduction may be imminent. In the 1980s, as the government became a minority shareholder, officials recognized that a situation might arise through the public trading of KLM shares in which one or more non-Dutch nationals might control a majority of the airline's shares. The dangers of `denationalization' might then appear: as a KLM report noted,
limitations or aggravating conditions [might] be imposed upon KLM, either under one or more of the international agreements or under one or more permits granted by any country, with respect to operation of scheduled flights because a predominant or majority shareholding of KLM's capital is not demonstrably in Dutch hands.
A foreign government and/or carrier might challenge KLM's status as a `Dutch' airline and withdraw its operating rights under the relevant bilateral agreement.
To guard against such a challenge, the Netherlands Government accepted an option agreement under which the state has the right to purchase up to 23 million shares at an agreed price in order to ensure that a majority of shares is in Dutch hands. This option might also be exercised if it is thought to be `necessary to prevent one person or group of persons or companies obtaining such a holding in KLM that an undesirable controlling position in the General Meeting of Shareholders of KLM is established'.

In Germany, a similar concern arose about protecting the citizenship of Lufthansa. Once the government sold its 35.7% shareholding. Under the Aviation Compliance Documenting Act, the shares of all publicly listed German airlines (not only Lufthansa) must be registered shares `whose transfer is subject to the consent of the company'. The stated purpose of the Act is to enable ready identification of shareholders (and their nationality), to alert airline managements to any risk of challenge on grounds of nationality, and to enable them to block purchase of shares or to force the sale of foreign-owned stock if in aggregate it approached 50% of the total. (Strictly, then, the issue is not takeover: it is the overall balance between foreign-owned and domestically-owned stock.)

The European Commission (and the European Court of justice) might well object to protective measures that seem to be directed equally at EU and non-EU nationals. The Commission has, indeed, objected repeatedly to exclusive nationality clauses in the ASAs of member states with non-EU states. It argues, logically enough, that such clauses are `contrary to Community law', because they prevent full exercise of the right of establishment and of the operating and licensing freedoms embodied in the three aviation liberalization packages. The Commission also claims that EU carriers and passengers will benefit more from a united approach to larger trading partners, such as the US, than from bilateral negotiations which, even under an `open skies' approach, deal only with traffic rights and not with a wider range of consumer and competition issues.

Why European airlines are vulnerable:
The problem for EU carriers and for member state governments is that a substantial part of the traffic carried by the major EU airlines is on routes outside the EU, and these routes continue to be covered by bilateral ASAs. In April 1997, some 74.4% of the mileage flown by members of the Association of European Airlines in scheduled international air transport was on routes beyond Europe; by contrast, the major US carriers flew, even at the height of the 1996 tourist season, only 35% of their revenue passenger-kilometers on international routes. In 1995, the AEA airlines carried nearly 18 million passengers across the North Atlantic alone, compared with 97 million on all intra-EU routes.

Equally important to understanding the politics of the industry -- and the strategies of particular airlines -- are the variations between carriers in how far they depend on external routes. In 1991, some 49% of KLM's international traffic, and 37% of both Air France's and BAs international traffic, was carried on long-range routes. In 1993, the British Civil Aviation Authority reported that long-haul routes accounted for 31% of BA's passengers, 60% of its turnover and 90% of its profits. BA had at that time a profit rate of 6.4% on transatlantic flights, compared to 2.9% on intra-European services -- and an impressive 22.5% on routes to Africa, the Middle East, and South Asia (the latter being routes typically governed by tightly restrictive bilaterals with service limited to a duopoly of national carriers)

The carriers with substantial exposure on long, range routes face the dilemma of coping with two different regulatory regimes (and with different degrees of competition under each of them). The older nationality-based Chicago system underpins all flights outside the EU, even those under so-called `open skies' agreements (which are simply liberalized bilaterals): the EU Single Market system permits unrestricted operation across and within borders, but only within the EU Single Market and only by airlines that qualify as `Community carriers'.
Such double regulation has serious implications for the completion of the Single Market in aviation and for consolidation of the European air transport industry. Suppose, for example, that Lufthansa wanted to start international flights from Madrid. It would be responding logically to the liberalization program, which envisages freedom of operation applying not only to routes between and within member states, but also to external routes from member states. In principle, Lufthansa might enter, say, the Madrid--Argentina market either directly or by buying shares in a Spanish airline with route authority (realistically, a privatized Iberia). But, pace the Commission, both the Spanish and Argentinian governments might deny it operating authority, since Germany is not a party to the relevant bilateral agreement. The alternative of buying into a Spanish airline might be blocked by legislation or corporate regulations like the Dutch option agreement. And even if Lufthansa effected a takeover, its triumph might be short-lived, if Argentina decided to challenge Iberia's status as a `Spanish' airline (and it might well do so in such a case, seeing the threat of extra competition in Lufthansa's move).

An alliance hierarchy:
The international regulatory regime and the dependence of the major EU carriers on routes thus stand in the way of completing the Single Market in air transport. They also obstruct any large-scale consolidation of the European airline industry (on the lines of the consolidation that occurred in the US after deregulation). The situation is ironic in that it has arisen just as privatization is creating opportunities, however limited, for cross-border mergers. It means that smaller national carriers are likely to survive, but that privately owned airlines which operate only within the EU are vulnerable to takeover. Such airlines by definition do not have the protection that exposure on long-haul routes paradoxically gives to the larger carriers: nationality-based ASAs between EU member states were abolished with the implementation of the Single Market.

Smaller private airlines may, indeed, be attractive to major national airlines to provide `feed' (a term the airline industry shares with ranchers) for their international hubs. A Lufthansa, locked out of Madrid, might concentrate instead on attracting Spanish passengers to Frankfurt by offering lower fares and more destinations and connections than Iberia can offer. This strategy is entirely feasible because airlines can now enter the intraEuropean and domestic routes of their rivals and can (subject to the reservations noted above) buy equity in airlines based in other member states. The danger for an Iberia is not that a `foreign' airline will start operating a shuttle between Madrid and Barcelona, but that it will take away both its European and long-haul passengers, directly or (more likely) by allying with or buying into a Spanish competitor. Alternatively (as indeed seems to be happening), Iberia and airlines in smaller and more peripheral member states may be drawn into alliances with larger carriers and with the latter's non-EU partners.
What we are likely to see in Europe, then, is a hierarchical arrangement, in which the larger carriers attach the smaller carriers to themselves as `clients' (which may be used to beat out such upstarts as Easy Jet and Virgin Express). Consolidation will have occurred, but without a significant reduction in the number of larger airlines. The latter are now creating a set of exclusive international hubs -- excluding their European peers and American and even Asian carriers other than their privileged US and Asian alliance partners by market dominance and control of airport slots. Delta's decision to scale back its operations at Frankfurt (where it had a long-haul and intraEuropean hub) in favor of such airports as Brussels and Zurich, where it enjoys alliances with national carriers, is an example of such exclusion at work -- the same kind of exclusion that other carriers complain will happen if the AA-BA merger occurs.

Transatlantic alliances are the other piece of the puzzle. They have developed because EU airlines have such large stakes in transatlantic routes and need greater access to the US domestic market, but face the obstacles that US ownership and control rules present to all foreign airlines trying to penetrate the American market. These require that, for purposes of obtaining operating authority within the US, at least 75% of an airline's voting stock must be held by US citizens. (Since 1991, up to 49% of total equity may be held by a foreign national, provided that the existing limit on voting shares is met.) Further, the president and at least two-thirds of the board of directors and `key management officials' must be US citizens. Finally, the US Department of Transportation is required to establish whether or not `effective control' of the airline is in US hands. The rules thus deny both acquisition of controlling equity and `cabotage' -- the right to offer transportation within a country's borders -- to foreign airlines.

Enterprise alliances -- starting with the KLM-Northwest alliance in 1988 -- are in fact a second-best solution to the normal commercial and investment options of direct establishment and equity purchase. As Leo van Wijk, the recently appointed chairman of KLM put it earlier: `Alliances are ... a reasoned response to an antiquated regulatory system .... [They] permit indirect access to restricted markets.' They do so, of course, for both partners: Northwest (unqualified as a `Community carrier') can draw traffic from KLM's European network, while KLM (prevented from carrying passengers within the US) draws traffic from Northwest's three US hubs. The partners are saved the expense of stationing aircraft and crews abroad, and code-sharing enables them to claim service between thousands of cities, even when most of the cities are in reality only visited by aircraft of one airline.

At least in the US, such code-sharing sometimes creates surrealistic scheduling. In Pittsburgh, roughly fifty domestic flights were advertised daily under the now-defunct BA-USAir alliance as BA services. If the arrivals and departures boards were to be believed, BA was flying daily from Pittsburgh to such unlikely BA destinations as South Bend, Indiana; Kalamazoo, Michigan; and Canton Akron, Ohio, much as if it was off to Aberdeen or Tiree. The reality -- revealed by a discreet star in the schedule and the words `Operated on behalf of British Airways by USAir' -- was the same old silver-and-red 737 or DC-9, not some rust-belt commuting 747.

Open skies: winners and losers:
The fashion for transatlantic alliances was established by KLM, which faces the dilemma of being a large airline with a small country. It was the smaller EU countries, too, that succumbed first to the blandishments of the US Department of Transportation's campaign for `open skies'. For the Netherlands, or Belgium, or Finland, `open skies' offered the prospect of being able to fly to any point in the US, while entailing little real threat of an American invasion of their own, necessarily small markets. As American critics said, such agreements blatantly defied the normal principle of `balance of benefits' -- a balance that could only be approached by direct negotiation between the EU as a whole and the US. However, while the European Commission was eager to assume authority for such negotiation, several of the larger Member-States -- protective of their own airlines and traffic rights -- opposed its doing so. The American strategy was therefore to pick off the smaller states, starting with those which were most dependent on long-haul routes, in the expectation that the lower fares and greater capacity offered under `open skies' agreements would draw passengers away from their more obdurate and larger neighbors.

This approach has succeeded -- spectacularly so, in demonstrating the potential of `open skies' to expand markets, and, more modestly so, in putting pressure on the neighbors. The clearest evidence in both respects comes from the Dutch case. By 1995, Amsterdam-Schiphol had overtaken Paris-Charles de Gaulle as the fourth largest European gateway, the number of transatlantic passengers flying through Amsterdam increasing by 74% from 1989 to 1994. The potential for market expansion was shown dramatically in the case of the new KLM-Northwest service between Amsterdam and Minneapolis, launched in April 1994. Starting with a capacity of 1942 seats each week, capacity on this route was increased to 9758 seats weekly by mid-summer to cope with demand; in August, a second daily flight was scheduled for the remainder of the season.

The Dutch `open skies' agreement is also widely credited with reversing the German opposition to `open skies'. KLM, which has consistently supplemented its market by luring passengers from Germany, was even more successful in diverting traffic from Lufthansa after 1992. As a matter of self-defence, Lufthansa reportedly became a convert to the `open skies' philosophy and itself urged the German Government to pursue such an agreement with the US government, which it concluded in 1996.
As the number of `open skies' agreements has increased, so the US Government has made signature of them a condition for approving the transatlantic alliances that have developed largely following a competitive dynamic of their own. `Open skies' agreements are also a condition for the antitrust immunity that the alliances seek from the US in order to achieve full integration of operations and marketing. A sceptic might say, however, that the American use of antitrust immunity has the paradoxical effect of opening markets while permitting a reduction in competition. In this respect, the BA-AA alliance is a logical consequence of American policy, as well as the last lap in the race to connect up with American carriers. Curiously, this alliance has provoked the Commission's competition directorate to take over the mantle of antitrust from the US Government. DGIV's activism comes so late in the game of alliance-building that suspicions of partiality naturally arise (can this be Air France's final revenge for so much suffering at the hands -- or under the wings -- of BA?).

Whatever the outcome of Washington's continuing battles with France and the UK over liberalization, the action across the North Atlantic has had two serious consequences for the structure and governance of aviation within the EU. First, it has undermined the effectiveness of the Commission's campaign to take over the role of aviation rights negotiator. The mandate that the Commission has from the Council of Ministers to negotiate over a `common EU-US aviation area' only covers traffic rights in a second phase (and it is mainly traffic rights that the US wants to discuss). More important, however, is the question of what difference these negotiations can make. The French and British clearly mean to negotiate with the US on their own terms (and neither will accede quickly or easily to a simple `open skies' formula). For the rest, a substantial portion of transatlantic traffic is already carried under `open skies' arrangements (albeit without the consumer protection and dispute resolution procedures that the Commission wants to add). The fact is that the shape of transatlantic aviation has already been settled by the carriers themselves, in cooperation or collusion with the governments of the US, Germany and most of the smaller member states. In this respect, again, the Commission seems to be late in the game -- or, rather, it is playing a game that has already been won and lost elsewhere. The market will not be carved up between trade blocs: it has already been sliced up sideways, between transatlantic airline alliances.

Who are the losers? Certainly not the major carriers, and -- in the sense of being absorbed -- not the smaller national carriers either. Of the latter, those based in the smaller, more peripheral member states are likely to be relegated to the role of `feeders' to the larger airlines. For reasons already suggested, they cannot be deprived of their long-haul routes (as long as the Chicago regime survives). But they may lose traffic to airlines with larger hubs and major American partners.
The second, less obvious consequence of transatlantic alliance-building has been to undermine the strategy of cooperation between the airlines of smaller European states pursued in the early 1990s by KLM, SAS, Austrian and Swissair. This strategy culminated in the so-called `Alcazar' project which envisaged the creation of a single carrier. Disagreement about choice of a US partner was, by most accounts, the reason for the collapse of negotiations over Alcazar in 1993: KLM insisted that the other three accept its current partner, northwest, while the others wanted to ally with Delta.

Concluding remarks:
This episode and its aftermath showed how transatlantic relationships could take precedence over cooperation between European airlines. All of the participants are now incorporated into competing alliance systems. KLM stayed in its profitable but unstable relationship with Northwest; Austrian, Swissair (and Sabena) became partners of Delta; and SAS accepted a junior role to Lufthansa in the `Star Alliance' with United, Thai, Varig and Air Canada. (SAS is, indeed, a rather ominous example of the subordination that may overtake airlines in the smaller, peripheral EU states.)
Politically speaking, the alliance system has also blurred the nationality of airlines. Both Washington and London are currently at the centre of some complicated pressures, with both British and US carriers divided against each other and the governments finding themselves united on certain fronts (notably against the Commission), yet opposed on others (notably over access to Heathrow for American carriers other than the incumbents). Virgin Atlantic has the services both of a Washington attorney who was a leading proponent of `open skies' in the early 1990s and of a former European Commission official.

Relations between governments and airlines are certainly becoming more complicated and ambiguous than in the days when this industry was held up as an exemplar of protectionism and state domination. The American strategy, in fact, assumes that airlines can be used as levers on government, in regions such as the EU and Asia where state ownership is still substantial. But even American policy has not yet made the major leap toward freedom of investment and operation that would undermine the Chicago regime. This was, after all, the one sector that participants in the negotiations over the General Agreement on Trade in Services unanimously agreed to exclude from the agenda.

Nationalism may be waning, and `national interest' may not have its former ability to overrule the commercial judgements of airline managements. But nationality and the Chicago regime are not yet dead. They have many friends -- declared and undeclared -- in both governments and airlines who are happy to see the regime linger yet a while. They have few enemies active or unsporting enough to risk their reputations by suggesting that it is time to dig a hole near O'Hare airport and bury the Chicago Convention in it.