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Luxembourg Financial Collaterals 3rd Ed., June 2011


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This brochure details the latest updates in the matter of Luxembourg financial collaterals

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Luxembourg Financial Collaterals 3rd Ed., June 2011

  1. 1. Luxembourg Financial Collaterals Structured Finance & Tax Third Edition - June 2011 Established in 1923
  2. 2. This third edition integrates the legislative updates introduced by the law of 20 May 2011.Luxembourg Financial Collaterals 2|P a g e
  3. 3. CONTENTSINTRODUCTION THE CHALLENGE: SECURING AN UNSECURED ENVIRONMENT ...................................... 4  THE LESSONS OF THE FINANCIAL CRISIS..................................................................................................... 5  WHY A TWO-TIER LUXEMBOURG SECURITY PACKAGE? .......................................................................... 7 THE TAX CHALLENGE ......................................................................................................................................... 8  TAX TREATMENT OF THE FUNDS FLOW THROUGH THE LUXEMBOURG TWO-TIER STRUCTURE..... 10  THE TAX TREATMENT OF THE PAYMENT OF INTEREST.......................................................................................... 10  THE TAX TREATMENT OF THE CAPITAL GAIN AND DIVIDEND INCOME DERIVED FROM THE BIDCO SPV ....... 12  THE TAX TREATMENT OF THE CAPITAL GAIN AND DIVIDEND INCOME DERIVED FROM LUXCO 2 .................... 14  THE REPATRIATION OF PROCEEDS TO THE INVESTORS ....................................................................................... 14  THE TAX IMPLICATIONS OF SECURITIES GRANTED AT THE LEVEL OF THE LUXEMBOURG COMPANIES ................................................................................................................................................... 17  THE TAX TREATMENT OF THE SECURITIES PROVIDED BY LUXEMBOURG COMPANIES ................................... 17  UPON ENFORCEMENT OF THE SECURITIES: SOME TAX ASPECTS ....................................................................... 17 THE SECURITY PACKAGE CHALLENGE .......................................................................................................... 20  HIGHLIGHTS OF THE LAW ON FINANCIAL COLLATERAL ARRANGEMENTS .......................................... 21  BACKGROUND – DIRECTIVE ON FINANCIAL COLLATERAL ARRANGEMENTS ...................................................... 21  THE LUXEMBOURG LAW ON FINANCIAL COLLATERAL ARRANGEMENTS – INTRODUCTION ............................. 21  THE LUXEMBOURG LAW ON FINANCIAL COLLATERAL ARRANGEMENTS – PLEDGE AGREEMENTS ................ 22  THE TWO-TIER LUXEMBOURG SECURITY PACKAGE ............................................................................... 29  THE FRAMEWORK: CREATING A FULL LUXEMBOURG SECURITY PACKAGE ....................................................... 29  THE PURPOSE: ENSURING THE FULL EFFICIENCY OF THE ENFORCEMENT PROCESS .................................... 30  LUXEMBOURG FINANCIAL COLLATERAL PRACTICE: LESSONS OF THE FINANCIAL CRISIS.............. 34  DEBT RESTRUCTURING: A RESISTANCE TEST FOR THE LUXEMBOURG FINANCIAL COLLATERALS ............... 34  THE ENFORCEMENT OF THE LUXEMBOURG FINANCIAL COLLATERALS EXERCISES PROVED THEIR EFFICIENCY .................................................................................................................................................................... 34  LEGAL ISSUES RAISED BY THE PRIVATE SALE MADE UNDER NORMAL COMMERCIAL CONDITIONS .............. 35  THE LITIGATION RISK .................................................................................................................................................... 36  THE PRE-INSOLVENCY AND INSOLVENCY RISK ....................................................................................................... 38 CONTACT ............................................................................................................................................................ 40 Luxembourg Financial Collaterals 3|P a g e
  5. 5. THE LESSONS OF THE FINANCIAL CRISISIn times of difficulty, traditional practices often have to be rethought.In the wake of ever-growing and booming M&A activity throughout the 1990s up to the 2008 financialdownturn, important issues for lawyers were how to implement an acquisition structure in a tax-friendly environment, maximize debt pushdown, minimize transaction taxes on funding and acquisition,build up an efficient interim repatriation of profits, set up a tax free exit and repatriation model and giveinvestors their expected return.In contrast, the guarantees’ aspects came like second in row at the time, as a required yet relativelyaccessory part of an acquisition’s package. Lenders required an acceptable security package as theirsole coverage against the default. However, in those happy days of positive thinking, a major defaultsituation was regarded as remote. Leveraged debt’s proportion was higher and higher, eachleveraged buyout (LBO) after each leveraged buyout, and it seemed that the sky was the limit.The situation drastically changed in 2008. Throughout the following years, the effect of the dramaticfinancial and economic worldwide downturn was immediate: a number of companies purchasedpursuant to recent highly leveraged buy-outs were no longer in position to fulfil their repaymentobligations and entered the default danger zone.There comes the time of debt restructuring … there comes the time of testing the resistance of thesecurity package …Indeed, there are circumstances in which the debt restructuring does not consist in simply refinancingthe existing acquisition structure. It may be that the initial investors are not willing or are not in positionto take part in the refinancing. The acquisition structure must be then partly or fully taken over byothers who are either one/several existing lender(s) or new investors. The security package must bethen dismantled and wholly reconfigured.For the first time in 2009, Luxembourg financial collaterals were subject to enforcement. Thatenforcement exercise was a première, quickly followed by further similar cases. Those enforcementexercises proved to be special opportunities to verify the efficiency of Luxembourg financial collaterals.They also raised a number of legal issues which had been untested up to then. Luxembourg lawyershad to find adequate responses and Luxembourg courts had to provide judicial interpretations oncritical legal issues.The present developments specifically aim at exposing, from a Luxembourg perspective, the lessonswhich may be drawn up from such enforcement tests. Hopefully, the interest of the followingdevelopments shall largely exceed the crisis period. In the future, as it has been in the past, leveragewill still be at the core of the LBO model. However, taking good note of the crisis’ lessons, lenders willbe more eager than ever to be comforted with a strong reliable security package. That will be the priceto pay for the lenders’ commitment and affordable credit conditions.Luxembourg Financial Collaterals 5|P a g e
  6. 6.  Reconsidering the Past  The security package issue has become a priority concern  Since 2008: a resistance test for the Luxembourg financial collaterals  Enforcement exercises confirmed the reliability and efficiency of the Luxembourg financial collaterals  Enforcement exercises raised a number of legal issues untested up to then…  …reinforcing legal know-how of Luxembourg practice  Luxembourg case-law: a strong judicial support for legal safety  Lenders are provided with a reinforced security packageLuxembourg Financial Collaterals 6|P a g e
  7. 7. WHY A TWO-TIER LUXEMBOURG SECURITY PACKAGE?For several years, the Luxembourg two-tier structure has been regarded as one of the most adequatesecurity package structures.In a nutshell, and as shown in the chart below, LuxCo 1, in its capacity as guarantor of the facilitieslent by the Lenders (Senior and Junior) to Bidco SPV, grants the Security Trustee financial collateralsover 100% of its assets.The Luxembourg two-tier structure actually aims at fulfilling two quite demanding challenges: i. providing a tax-friendly structure; and ii. establishing an efficient security package. The two pillars of the Luxembourg two-tier structure are: (i) Tax optimization; and (ii) Security package efficiencyLuxembourg Financial Collaterals 7|P a g e
  8. 8. THE TAX CHALLENGEWhile the two-tier structure provides an efficient security package to thelenders, it also provides a comprehensive tax planning package. Today,Luxembourg is still the favorite jurisdiction for many investors due to its tailor-made tax efficient system.Luxembourg Financial Collaterals 8|P a g e
  9. 9. An acquisition structure organised in Luxembourg does not have, in principle, specific taxes levied onit upon its implementation: on 1 January 2009, Luxembourg abolished the 0.5% capital duty whichhas been replaced by a EUR 75.- fixed registration fee and Luxembourg does not levy any stamp dutyupon transfer of the shares of a Luxembourg companyDepending on the nature of the investments (real estate, private equity, multiple targets, etc.) and thestatus of the investors (qualified investors or not), the Luxembourg double-tier structure can be set upthrough Luxembourg by the use of two Luxembourg unregulated companies having the object of aSoparfi. The Soparfi (Société de participation financière) is a standard commercial companyorganised under one of the corporate forms (public limited liability company (SA), private limitedliability company (Sàrl) or, limited partnership (SCA)) set forth by the law of 10 August 1915 oncommercial companies, as amended. The Soparfi is therefore treated as a standard company, eitherfrom a corporate point of view (there are no restrictions relating to its corporate object, which can bebroadly drafted) or from a tax perspective (Soparfis are fully taxable companies). As a result, Soparfisare not excluded from the benefit of the tax treaties concluded by Luxembourg or from the benefit ofthe EU Parent-Subsidiary Directive regime.As indicated on the above structure, the acquisition will in general be financed through differentchannels: i. through third party debt (shown as the senior and junior lenders providing senior facility and mezzanine facility); ii. through shareholders’ equity (shown as share capital); and iii. through shareholders debt, which can be of different kinds (shown as shareholders CPECs and receivables).  A structure in favour of the investors and the lenders: a strong reliable security package coupled with an efficient tax structure  The benefit of the participation exemption regime  Several possibilities of proceed repatriation with limited tax leakage  Possibility to avoid tax leakage upon enforcement of the Luxembourg securitiesLuxembourg Financial Collaterals 9|P a g e
  10. 10. TAX TREATMENT OF THE FUNDS FLOW THROUGH THE LUXEMBOURG TWO-TIER STRUCTURETHE TAX TREATMENT OF THE PAYMENT OF INTERESTAs indicated in the above standard structure, interest payments will be made by the two Luxembourgcompanies on inter-company loans. The payment of interest by a Luxembourg company is generallynot subject to withholding tax (“WHT”), except in certain limited cases, which can be summarised asfollows:  Profit allocations paid to a silent partner investing in a business and remunerated in proportion to the business’ profits;  Interest paid on profit-sharing bonds or notes;  Interest qualifying as savings income within the scope of the EU Savings Directive on taxation of savings income, unless the beneficiary elects for an exchange of information.In principle, interest payments made by a Luxembourg Soparfi qualify as deductible expenses unlessthey are in direct relation to exempt income. Where Bidco SPV is the borrower, the standardLuxembourg double-tier structure would generally allow Bidco SPV to have the interest paid to thelenders as deductible expenses. On-lent by Luxco 1 made on an arm’s length basis, i.e. Luxco 1realises an arm’s length margin on this financing activity which would be subject to corporate incometax (“CIT”) and municipal business tax (“MBT”), is disregarded for thin capitalisation rules purposes.Luxembourg Financial Collaterals 10 | P a g e
  11. 11.  Interest paid on the CPECs/Receivables is in principle deductible at the level of LuxCo 2 and LuxCo 1  CPECs/Receivables are disregarded for thin capitalisation rules purposes at the level of LuxCo 1  A small margin remains taxable at the level of LuxCo 1  Interest paid on the Senior or the Mezzanine Facility is in principle deductible at the level of Bidco SPV.Luxembourg Financial Collaterals 11 | P a g e
  12. 12. THE TAX TREATMENT OF THE CAPITAL GAIN AND DIVIDEND INCOMEDERIVED FROM THE BIDCO SPVThe capital gain realised by LuxCo 2 upon transfer of its participation in Bidco SPV is in principlesubject to CIT and MBT levied at the current combined rate of 28.59% (this is the current rate forcompanies established in the city of Luxembourg – this rate is expected to rise up to 28.80% as from1 January 2011), except where the participation exemption conditions are the following ones: i. LuxCo 2 needs to hold Bidco SPV for a 12 month period; ii. LuxCo 2 needs to have a minimum participation of 10% in the share capital of Bidco SPV or alternatively Bidco SPV’s acquisition price is at least EUR 6 million; and iii. Bidco SPV is covered by Article 2 of the EU Parent-Subsidiary Directive or is subject to a “Luxembourg comparable tax”. If these three conditions are met, the capital gain realised by LuxCo 2 upon transfer of its participation in Bidco SPV will be tax exempt in Luxembourg.The application of the participation exemption regime and the extent of such application may besubject to certain restrictions where, for example, financing expenses relating to the acquisition of theparticipation have been previously deducted (for example if the participation is financed by an interestbearing debt instrument). In such a situation, a recapture mechanism may apply1.The holding period applies with respect to the minimum shareholding only (10% or a EUR 6 millionacquisition price). This means in practice that holding period is deemed to be continued until the lasttranche equal to the required minimum stake (10% or a EUR 6 million acquisition price) is transferred.For example, if LuxCo 2 acquires 100% of Bidco SPV shares on 1 August 2010, any capital gainsrealised by LuxCo 2 upon successive transfers of up to 90% of Bidco SPV shares before 1 August2011 will be tax exempt in Luxembourg.Finally, the conditions allowing LuxCo 1 to benefit from the participation exemption upon realisation ofa dividend income by LuxCo 2 are similar to the conditions mentioned above for the capital gainexcept that the acquisition price of the participation alternative criteria, is EUR 1.2 million instead ofEUR 6 million.Bidco SPV should also ideally (but this is not mandatory for an efficient tax structure) be located in acountry offering a dividend WHT exemption on dividend payments made to LuxCo 2. A companylocated in EU countries should offer such exemption, provided, inter alia, that the Luxembourgstructure meets such EU countries standards substance.1 Under the recapture system, the exempt amount of the capital gain is reduced by expenses incurred (mainly derived fromthe participation, e.g. interest expenses, and potential write-downs in the value of the participation), to the extent that theyhave reduced the taxable base of that year or previous years.Luxembourg Financial Collaterals 12 | P a g e
  13. 13. At the level of the BidCo SPV: The BidCo SPV should be set up to mitigate or avoid completely WHT on dividend payments. At the level of LuxCo 2: Dividends are tax exempt if the BidCo SPV i. falls within the scope of the EU Parent-Subsidiary Directive; or ii. is a non-resident company subject to a tax corresponding to Luxembourg corporate income tax and LuxCo 2 holds or commits to hold during at least 12 months a shareholding of 10% or having an acquisition price of € 1.2 million (dividends) or € 6 million (capital gains)Luxembourg Financial Collaterals 13 | P a g e
  14. 14. THE TAX TREATMENT OF THE CAPITAL GAIN AND DIVIDEND INCOMEDERIVED FROM LUXCO 2The funds flow between the two LuxCos does, in principle, not trigger any tax leakage. Subject tocertain conditions, the distribution of dividends can be made free of withholding tax at the level ofLuxCo and the dividend or capital gain income should be tax exempt at the level of Luxco 1.The interest income realised by LuxCo 1 will be off-set against the interest expenses resulting fromthe mirroring debt existing at the level of LuxCo 1 (except for an arm’s length margin on the financingactivity).THE REPATRIATION OF PROCEEDS TO THE INVESTORSLuxembourg displays several well trodden paths allowing efficient tax planning structures used toupstream the funds back to the investors. Several instruments can be used, depending on the needsof the investors.  Hybrid instruments: PECs/CPECsPECs (Preferred Equity Certificates) and CPECs (Convertible Preferred Equity Certificates) are hybrid(debt/equity) instruments which can have several other denominations and which have beendeveloped by Luxembourg practice over the last few years. They are usually used to finance aninvestment realised by a Luxembourg company. These instruments are not regulated by law or byadministrative guidelines. These instruments qualify as hybrid instruments due to their features, whichare a subtle combination of equity and debt. The common equity features of the PECs and the CPECsare: i. a long term period (usually 30 years but may be more, depending on the specificity of the structuring at stake and the requirements of the Luxembourg tax authorities); ii. the “stapling” of the PECs/CPECs to the shares (i.e. if the shares are transferred, the PECs/CPECs should also be transferred); iii. the qualification of the PECs/CPECs as transferable securities; and iv. their subordination in relation to other debts of the issuing company (but ranking prior to the share capital).From a Luxembourg accounting and tax perspective, holders of the PECs/CPECs are usuallyconsidered as creditors. As a result, they do not have voting rights and do not bear any losses of theissuing company. In the jurisdiction of the holder of the PECs/CPECs, holders are normallyconsidered as having equity.Luxembourg Financial Collaterals 14 | P a g e
  15. 15. The PECs/CPECs are flexible, made-to-measure, instruments. They may be convertible into sharesor, upon exit (the exit events being set out in the PECs/CPECs terms and conditions negotiatedbetween the issuer and the subscriber), can be redeemed at market value without triggering anywithholding taxes (which is very efficient for exit scenarios). They can bear a yield or be yield-free.  Income-Sharing DebtIncome sharing debt, such as profit participating loans (“PPL”), can also be used as an exit strategyinstrument at Luxembourg level. In general such debt instruments would take the form of a loan,whose performance would actually depend on the income realised at the level of the Luxembourgcompany. Provided the instrument is properly drafted, the payment of that variable interest is inprinciple not subject to Luxembourg withholding tax (although a residual withholding tax may have tobe levied depending on the financing structure in Luxembourg) and is fully deductible. The use ofincome sharing debt may be particularly useful when the income derived from a subsidiary andrealised by a Luxembourg company is not eligible for the participation exemption (this should not bethe case in the analyzed double-tier structure regarding dividends paid by Luxco 2 to Luxco 1) and/orwhen the dividends paid by a Luxembourg company to its shareholders may be subject toLuxembourg withholding tax.Double-tier structure also allows a higher indebtedness since LuxCo 1 would on-lend thefunds to LuxCo 2. Provided that certain conditions are met (in particular leaving an arm’slength taxable margin on this financing activity), such on-lending allows the shareholders’debt (e.g. PECs, CPECs, PPLs, etc.) as being disregarded for the Luxembourg debt to equityratio (being 85:15).  LiquidationLiquidation is a well-known Luxembourg exit strategy. A Luxembourg resident company which is putinto liquidation is considered to dispose of all its assets and liabilities at their fair market value.Deemed capital gains are in principle exempt if the conditions required for the domestic participationexemption regime are met. No tax is withheld on the distribution of a liquidation surplus.At the level of the investor, a non-resident shareholder is deemed to realise a capital gain uponliquidation of the Luxembourg company in which he holds a participation. Realising a capital gainupon the sale of shares in a Luxembourg company is taxable in Luxembourg only if such non-residentshareholder has held a participation of more than 10% in the company’s share capital which isalienated (i.e. liquidated) within six months of its acquisition or if such shareholder has been a residenttaxpayer for 15 years and surrendered its tax residence less than five years before the alienation. Asa result, the taxation of a liquidation surplus received by a non-resident shareholder is applicable onlyin rare cases.Luxembourg Financial Collaterals 15 | P a g e
  16. 16.  Classes of SharesLuxco 1 can also be set up with a share capital represented by several classes of shares (usually upto ten classes) allowing for repatriation of profits via withholding tax exempt redemption of suchclasses of shares (i.e. partial liquidation of one class of shares). This tax treatment is however subjectto a prior written confirmation from the tax inspector. Payment of dividends: LuxCo 1 should be set up to avoid/mitigate WHT on dividend payments Payment of interests: In principle, not subject to WHT Payment made under hybrid instruments: In principle, no WHT – Taxable margin or max. 2.25% WHT Liquidation / Partial liquidation of LuxCo 1: No WHT – No Luxembourg taxation at the level of non-resident shareholdersLuxembourg Financial Collaterals 16 | P a g e
  17. 17. THE TAX IMPLICATIONS OF SECURITIES GRANTED AT THE LEVEL OF THELUXEMBOURG COMPANIESTHE TAX TREATMENT OF THE SECURITIES PROVIDED BY LUXEMBOURGCOMPANIESWhen a Luxembourg company provides guarantees, the questions of transfer pricing and deemedremuneration should be considered. An upstream guarantee: theIn principle, Luxembourg practice does consider when a Luxembourg company guaranteesLuxembourg company provides with a downstream guarantee, the obligations of its parentin favour of one of its subsidiaries, such parent company company.needs not be remunerated by such subsidiary. However,attention should be paid when a Luxembourg company grants A cross-stream guarantee: thean upstream guarantee or a cross-stream guarantee. In such Luxembourg company guaranteesa case indeed, the Luxembourg tax authorities may consider the obligations of a sisterthat the Luxembourg company should be allocated an company).appropriate guarantee fee in remuneration of such services.UPON ENFORCEMENT OF THE SECURITIES: SOME TAX ASPECTSDepending on the alternative chosen by the creditors in proceeding to the enforcement of thesecurities, specific tax aspects may rise. A typical implementation method, is the pledgee selling orcausing the pledged assets (in our example the Luxco 2 shares, CPECs, and receivables) to be soldin a private transaction at normal commercial terms (conditions commerciales normales) to an SPVset up for the purpose of the enforcement.  Stamp Duty upon Transfer of the AssetsAs a principle, no transfer tax or stamp duty is due upon transfer or enforcement of shares, CPECs orreceivables (unless the transfer deed is registered on a voluntary basis).  Capital Gains Realised by the Pledge/Security Trustee upon Transfer of the AssetsIt is likely that Luxco 1 will not realize any capital gain upon enforcement of the securities by thepledge or the security trustee. However, once the assets transferred to the SPV, such SPV may inturn transfer the assets to a third party. In this case, care should be taken regarding the taxation ofpossible capital gains realised upon transfer. We recall that capital gains realised by a fully taxablecompany residing in Luxembourg (the SPV in our example) are in principle subject to CIT and MBT.However, Luxembourg law and the grand-ducal decree of 21 December 2001, provide that capitalLuxembourg Financial Collaterals 17 | P a g e
  18. 18. gains, realised by a Luxembourg company on the disposal of shareholdings, are tax exempt providedthat the conditions of the participations exemption regime are met.These conditions are as follows: i. the SPV (provided that it is an eligible Luxembourg company) needs to hold Luxco 2 for a 12 month period; ii. the SPV needs to have a minimum participation of 10% in the share capital of Luxco 2 or alternatively the Luxco 2 acquisition price is at least EUR 6 million (this is unlikely – the transfer price of Luxco 2 shares and receivables to the SPV being usually symbolic); and iii. Luxco 2 is a fully taxable company (which is the case if Luxco 2 is incorporated under the form of a Soparfi).In case enforcement is made through a direct appropriation by the pledgee of the assets (in particularthe shares of Luxco 2) and if the pledgee is a non-Luxembourg resident, such non-residentshareholder will not be subject to capital gains or income tax in Luxembourg, except where: i. such non-resident shareholder is domiciled, resides or has a permanent establishment in Luxembourg; or ii. such non-resident holds more than 10% of the shares of Luxco 2 and disposes of such shareholding within six months as from the date of acquisition; or iii. in certain very limited cases, when such non-resident is a former resident of Luxembourg who holds more than 10% of the shares of Luxco 2.  Taxation of the Income InterestInterest income realised by a fully taxable company residing in Luxembourg (the SPV in our example)is in principle subject to CIT and MBT. These interest incomes can however be off-set against interestexpenses. Since it is unlikely that interest expenses would be available at the level of the SPV, the taxtreatment of the waiver of the existing inter-company receivable should be considered.  Waiver of Debt SPV toward Luxco 2Upon enforcement of the pledge, the SPV may become a creditor towards Luxco 2. It is likely thatLuxco 2 will not be in a position to repay such CPECs or any interest due. One possibility to re-establish, at least partially, Luxco 2’s financial position would be to proceed to a waiver of debt. Inprinciple, such a waiver of debt should result in a taxable profit in the hands of Luxco 2, which can beoffset by current year losses or, if available, tax losses carried-forwards. In addition, the gain resultingfrom such a waiver may be exempt at the level of Luxco 2 under certain conditions, one of which isthat such waiver is granted with the intention of re-establishing the debtor’s financial situation (en vuede l’assainissement de l’entreprise).Luxembourg Financial Collaterals 18 | P a g e
  19. 19. If the pledgee is a Luxco 2’s shareholder (which is likely after enforcement of a share pledge), awaiver of debt may be qualified as a hidden contribution in favour of Luxco 2 in application of theeconomic analysis principle. In such a case, there should be no profit recognition and losses carriedforward may remain intact at the level of Luxco 2.Such analysis should of course be made on a case by case basis.  0.24% Registration DutyIn principle, loan agreements (excluding, among others, bond issuances and other negotiableinstruments) are subject to an ad valorem duty of 0.24% where they are registered. The taxable basisof this 0.24% should be the principal amount of the principal mentioned in the agreement subject toregistration. Although the registration of loan agreements is not mandatory at the time the loanagreement is entered into, Luxembourg courts may order the registration of all documents that areproduced in Luxembourg proceedings. Attention should therefore be paid when drafting the pledgeagreement in order to mitigate such risk of taxation.Luxembourg Financial Collaterals 19 | P a g e
  20. 20. THE SECURITYPACKAGE CHALLENGEFrom the outset, Luxembourg regarded the EU Directive 2002/47 EC onfinancial collateral agreements (the “Directive on Financial CollateralArrangements”) as a unique opportunity to implement into its nationallegislation a legal instrument fully protective of the interests of the lenders.The law of 5 August 2005 on financial collaterals (the “Law on FinancialCollateral Arrangements”) has embodied such mechanisms in acomprehensive manner placing Luxembourg financial collaterals in a leadingposition. The latest amendments to the Law on Financial CollateralArrangements, which were introduced by the law of 20 May 2011, haveconfirmed the friendly-creditor features of the Luxembourg legal framework.Luxembourg Financial Collaterals 20 | P a g e
  21. 21. HIGHLIGHTS OF THE LAW ON FINANCIAL COLLATERAL ARRANGEMENTSBACKGROUND – DIRECTIVE ON FINANCIAL COLLATERAL ARRANGEMENTSAs part of the EU single market scheme, the need was felt to favor a harmonized regime for financialcollateral arrangements. The implementation of that harmonized Community regime was regarded assoundly contributing to the integration and cost-efficiency of the financial market as well as to thestability of the financial system, thereby supporting the freedom to provide services and freemovement of capital in the single market in financial services.The Directive on Financial Collateral Arrangements targeted one main objective: providing themaximum legal comfort to the security holders. Three main guidelines were drawn up in that respect: i. favour the contractual freedom between the parties to allow tailor-made financial collaterals’ structuring; ii. limit as much as possible the perfection and enforcement formalities; and iii. protect the beneficiaries of the financial collaterals against the negative impact of any insolvency or similar proceedings.THE LUXEMBOURG LAW ON FINANCIAL COLLATERAL ARRANGEMENTS –INTRODUCTIONLuxembourg law had already anticipated some of the innovations of the Directive on FinancialCollateral Arrangements pursuant to, in particular, the law of 1 August 2001 on the transfer ofownership as guarantee.The Directive on Financial Collateral Arrangements was therefore regarded by the Luxembourglegislator as a unique opportunity to implement into national legislation a legal instrument fullyprotective of the interests of lenders. Legal certainty is at the core of the Law on Financial CollateralArrangements.The Law on Financial Collateral Arrangements has coordinated in one set of provisions a number ofdisparate legal provisions, forming an easily readable legal unity. Part II of the Law on FinancialCollateral Arrangements sets forth a comprehensive legal regime for pledge agreements, whichderogates from the general pledge legal regime set out in the Luxembourg Civil Code and theLuxembourg Commercial Code.The Luxembourg legislator is eager to take any opportunity to improve the Law on Financial CollateralArrangements. Such an opportunity arose in the context of the transposition into Luxembourg law ofLuxembourg Financial Collaterals 21 | P a g e
  22. 22. the European directive 2009/44/EC of 6 May 2009, which has amended in particular the Directive onFinancial Collateral Arrangements. Within this transposition exercise which was enacted by the law of20 May 2011, the Luxembourg legislator re-assessed its policy: - integrate the European originated amendments into the single body of law which is constituted by the Law on Financial Collateral Arrangements, as now amended; and - exceed the minimum European requirements by further strengthening the added value of the Law on Financial Collateral Arrangements.THE LUXEMBOURG LAW ON FINANCIAL COLLATERAL ARRANGEMENTS –PLEDGE AGREEMENTS  Pledge Agreements: a Long-Tested Legal RegimeThe general regime of a pledge in the context of the Law on Financial Collateral Arrangements followsthe general outlines of the legal regime of the pledge, set out in Articles 2071 seq. of the LuxembourgCivil Code.As a private agreement pursuant to which a debtor (the pledgor) allocates a particular asset or acategory of assets to his creditor as a guaranty, the pledge is a legal instrument well-known toLuxembourg practitioners, the legal regime of which having been thoroughly interpreted for decadesby the Luxembourg courts.  Limited CostConsidering the considerable financial implications that the financial collateral arrangementsrepresent for the investors and the lenders, implementation of Luxembourg financial collaterals underthe form of pledges is generally limited to legal fees.Further, in terms of incorporation cost of LuxCo 1 and LuxCo 2, the most commonly corporate vehicleused is the Sàrl, with a minimum subscribed share capital of EUR 12,500. Also, some of the fundsused to pay in the share capital of LuxCo 1 may be further used, at least in part, by LuxCo 1, for thepurpose of paying in the share capital of LuxCo 2 at incorporation.In terms of contractual legal paperwork, the financial collateral arrangements will be mainlyrepresented by one or several standard pledge agreements (share pledge agreement, hybridinstruments’ pledge agreement, account pledge agreement, receivables’ pledge agreement), whichwill be governed by the Law on Financial Collateral Arrangements.Pursuant to Article 26 of the Law on Financial Collateral Arrangements, Luxembourg financialcollaterals are not subject to any taxes or registration duties. In case of voluntary registration by oneor either parties, they are subject to a EUR 12 flat registration fee. It is only in very limited cases that a0.24% ad valorem duty may be due (cf. section “Upon enforcement of the securities: some taxaspects”).Luxembourg Financial Collaterals 22 | P a g e
  23. 23.  Unrestricted Personal ScopeThere are no restrictions under the Law on Financial Collateral Arrangements in respect of thepledgor. The pledgor may be a private individual or a private or a public corporate body. It may be themain debtor or it may act as a guarantor for a third party’ debt.The same is true for the pledgee.  Full Recognition of the Security Trustee’s Capacity and PowersIn the context of syndicated financing, the Law on Financial Collateral Arrangements has addressed aspecific issue relating to the involvement of a security trustee holding the pledged assets on trust, forthe benefit of the lenders. This security trustee’s intermediation traditionally raised a legal difficulty,due to the fact that under the Continental civil law principles, the pledge is a security which is anaccessory to the underlying secured debt. As a result, the pledgee must necessarily be the creditor ofthe underlying debt. The standard concept of “créancier-gagiste” mirrors that intrinsic link between thesecurity (pledge) and the underlying secured debt. The security trustee is not necessarily the creditorof the secured debt. In order to respond to the issue originating in a conflict between common lawmechanisms (trust) and civil law principles, the practice used various legal devices, such as a so-called parallel debt between the security trustee and the borrower.The Law on Financial Collateral Arrangements expressly sets forth that a financial collateralarrangement may be set up in favour of a trustee for the purpose of securing the rights of third parties(lenders). Most importantly, the Law on Financial Collateral Arrangements states that the trusteebenefits from the same rights as the rights conferred to a “créancier-gagiste”, without any prejudice toits specific obligations as trustee vis-à-vis the lenders.  Scope of the Underlying Secured DebtAny and all current, future, term or conditional obligations may be secured by a pledge agreement inthe meaning of the Law on Financial Collateral Arrangements, whether these obligations are owed bythe pledgor or by a third party.  Pledgeable AssetsAny types of receivables and financial instruments may be subject to a pledge agreement within themeaning of the Law on Financial Collateral Arrangements. The Law on Financial CollateralArrangements expressly states that the idea of pledgeable assets must be interpreted as widely aspossible including:Luxembourg Financial Collaterals 23 | P a g e
  24. 24.  Any transferable securities, including shares and any other equitable securities, bonds and any other debt securities, deposit certificates, receipts, and bills of exchange;  Any securities giving right to acquire shares, bonds or any other securities by means of subscription, purchase or exchange;  Futures and securities payable in cash, including money market instruments;  Any other property, debt or transferable securities;  Any securities relating to financial, commodities, risks or a good’s underlying assets;  Any receivables relating to any of the above instruments.This list is not exhaustive. In addition, the Law on Financial Collaterals expressly sets forth that theabove listing covers any such financial instruments, whether they are materialised or non-materialised, transferable by registration or by delivery, endorsable or not and whatever the governinglaw thereof.In practice, the effect of the comprehensive scope of pledgeable assets under the Law on FinancialCollaterals is that all assets held by LuxCo 1 are in principle subject to pledge, whether the sharessubscribed in the share capital of LuxCo 2, bonds and hybrid instruments (PECs, CPECs, PPL Notes,etc.) issued by LuxCo 2, receivables held by LuxCo 1, or money in a bank account. This broadinterpretation of pledge is a noteable feature of the Law on Financial Collaterals for investors andlenders.  Ownership/Dispossession of the Pledged AssetsOne specific aspect of the pledge under Luxembourg law is dispossession of the pledged assets fromthe hands of the pledgor, to the hands of the pledgee or an agreed third party. As a result, thepledgee does not incur the risk of having the pledged assets escaping its control as long as thepledge remains in place.The ownership of the pledged assets remains in the hands of the pledgor. The difficulty may be for thepledgee to ascertain the pledgor’s ownership, at the risk of having the pledge put at risk in the eventthe ownership is uncertain or claimed by a third party. The Law on Financial Collateral Arrangementsaddresses that cause for discomfort as follows:  the pledgor is deemed to be the owner of the pledged assets;  the validity of the pledge is not affected by the default of ownership of the pledgor, unless the pledgee was informed in advance in writing of such default of ownership;  in case the pledgor duly informed in advance the pledgee about the default of ownership, the validity of the pledge is subject to the confirmation by the pledgor that the owner of the pledged assets has accepted the pledge.Luxembourg Financial Collaterals 24 | P a g e
  25. 25.  Tailor-Made and Light Formalities of Implementation and DispossessionIn the context of immaterial assets such as financial instruments, receivables, assets held on bankaccounts, the Law on Financial Collateral Arrangements sets up an informal process ofimplementation and dispossession of pledged assets, either by way of registration (registeredfinancial instruments), informal notification to the issuer (shares, equity instruments) or to the debtor(receivables). All formalities of implementation and/or dispossession of the pledges do not require any intervention of public authorities (courts) or officers (e.g. notaries, bailiffs, etc.). This has a positive cost and time saving effect.  Right to Set up Multi-Ranking PledgesComplex financing transactions generally involve the principle of subordination of certain debts. Thisis especially the case where there are senior lenders and junior lenders (e.g. mezzanine financing).In that situation, there may be a sound interest for the various lenders to take advantage from multi-ranking pledges. In practice, a subordinated lender will be in position to enjoy the benefit of a pledgeover assets which have already been pledged as first-ranking security in favour of a senior lender.The Law on Financial Collateral Arrangements implemented the possibility to set up multi-rankingpledges. Noticeably, multi-ranking pledges may be set up ad infinitum and are not limited to second-ranking pledges.  Contractual Freedom for Determining Voting Rights, Dividends’ Distributions and Use of the Pledged AssetsIn respect of the allocation of the voting rights and rights to dividends over pledged shares or othersecurities granting such rights, the Law on Financial Collateral Arrangements adopts a liberalapproach by allowing the parties to allocate voting rights and dividends to each other according to thebest of their respective interests. Where the pledgee has the voting rights, it allows him to conveneshareholders’ meetings, take shareholders’ resolutions or to dismiss the management in place andappoint new managers. This wide scope of action granted to the pledgee was expressly confirmed bythe law of 20 May 2011. Those rights are of a particularly significant as it allows a pledge to control the pledged shares in the event of default.The pledgee may also use the pledged assets without affecting the effectiveness of the pledge.Luxembourg Financial Collaterals 25 | P a g e
  26. 26.  The provider of a financial collateral can waive in anticipation any rights of subrogation or recourse it may haveThis issue had proved critical in the context of several debt restructuring scenarios which took place inLuxembourg. By way of legal subrogation, the pledgor, which was deprived from its shares pursuantto the enforcement of the pledge over those shares, was subrogated in the rights of the pledgee andthen had a claim – equal to the value of the shares subject to enforcement - against any other debtorsor guarantors of the secured claims. As a result, the risk was that the pledgee took control – in case ofappropriation of the pledged shares – of an entity which became itself the debtor of the pledgor. Thissubrogation effect was clearly detrimental to the interests of the pledgee and substantially diminishedthe value of the pledged assets.In practice, this risk was covered by specific provisions in the pledge documentation: the pledgorexpressly waived any rights of subrogation or recourse, either legally or contractually-based, it mayhave. However, it was questionable whether this anticipated waiver fully met the Luxembourg civil lawprinciples. It was therefore desirable that the Law on Financial Collateral Arrangements clarify thisissue. The Luxembourg legislator took the opportunity of the law of 20 May 2011 to meet thisexpectation.  Full Immunization against the Pre-Insolvency or Insolvency Risk of the Pledgor  A top priority concern for the Luxembourg legislatorThe protection of a pledgee’s rights in the event of a pledgor’sinsolvency is obviously a major concern. Pre-insolvency and Taking the guidelines of theinsolvency measures generally generate suspension or even Directive on Financial Collateralnullification effects vis-à-vis any types of guarantees which may Arrangements to the word, thebe held against an insolvent debtor. Law on Financial Collateral arrangements provides aThat major topic was addressed by the Directive on Financial comprehensive set ofCollateral Arrangements as a primary concern at a coordinatedEU level. However, the Member State’s legislations have mechanisms aiming at fullyadopted rather dissymmetrical approaches with regard to the protecting the pledgee’s rightsfair balance level to be set up between those two conflicting against the insolvency matters. In particular, some jurisdictions are less prone Luxembourg courts have giventhan others to favor the interests of the pledgee to the detriment full force to that protection.of other interests, namely the interests of other creditors orworkers.While transposing the Directive on Financial Collateral Arrangements, the Luxembourg legislator wasmiles away from such a multi-interests’ approach: the protection of the lender/pledgee was theprimary concern.Luxembourg Financial Collaterals 26 | P a g e
  27. 27.  Express legal provisionsClaw-back period’s limitations are a cause for major concern for guarantee holders. Article 20 (1) ofthe Law on Financial Collateral Arrangements expressly excludes any claw-back risk by stating thatthe financial collateral arrangements, as well as the facts triggering the enforcement thereof, are validand enforceable vis-à-vis third parties, commissars, curators, receivers, liquidators or other similarorgans notwithstanding any Luxembourg or foreign pre-insolvency or insolvency measures, as well asvis-à-vis civil or criminal seizures. That core principle is repeated in even stronger words in Article 20(4) of the Law on Financial Collateral Arrangements.Further, the Law on Financial Collateral Arrangements extends the protection to pledges concludedon the opening date of the pre-insolvency or insolvency measures, provided that, where the pledgewas agreed after the actual opening of such measures, the pledgee was unaware that such measureswere previously ordered. This legal provision is a deliberate exception to the “zero-hour” principle,which normally applies in respect of the ordering of pre-insolvency or insolvency measures. Itdemonstrates to what extent the Luxembourg legislator intended to immunise financial collaterals.Fully aware that Luxembourg financial collaterals are most generally concluded in the context ofinternational transactions, the Luxembourg legislator was eager to extend the pledgee’s protectionagainst the potential risks incurred by foreign pre-insolvency or insolvency measures which may applyvis-à-vis the pledgor and/or the pledged third party. Article 20 (1) of the Law on Financial CollateralArrangements fully embodies such extension, which may be regarded as an extra-territorial loi depolice, evidencing the willingness of the Luxembourg legislator to cover the widest scope ofimmunization of the Luxembourg pledges against the pre-insolvency and insolvency risks.  The strong case-law supportMost importantly, Luxembourg courts have given full force to that protection granted by Articles 20 (1)and 20 (4) of the Law on Financial Collateral Arrangements: - a criminal seizure does not have as effect to affect the pledge arrangements or the right of the pledgee to enforce the pledge (Chamber of council of the district court of Luxembourg, 14 October 2010); - Article 20 (4) of the Law on Financial Collateral Arrangements must be regarded not only as a mandatory legal provision, yet as a loi de police aiming “at sheltering financial collateral arrangements against any challenges, therefore giving lenders a fully secured legal framework” (Court of appeal of Luxembourg, 3 November 2010).Luxembourg Financial Collaterals 27 | P a g e
  28. 28. LUXEMBOURG PLEDGES’ MAIN HIGHLIGHTS  Luxembourg pledge arrangements are concluded under the form of private agreements not subject to any burdensome formalities, intervention of public authorities or officers (notaries), registration requirements or taxes/registration duties  Cost-efficient  No restriction concerning the identity of the pledgee or the pledgor  The security trustee’s rights are given full force and effect  Pledgeable assets are not restrictively defined and may cover any kinds of receivables and financial instruments  The ownership issue is covered by a presumption of the pledgor’s ownership  Light formalities for dispossession evidence the non-formalistic approach followed by the Law on Financial Collaterals Arrangements  Right to set-up multi-ranking pledges  Full contractual freedom for determining voting rights and dividends’ allocations between the pledgor and the pledgee, allowing the pledgee to further take full control of LuxCo 2  Full immunisation effect against the pre-insolvency or insolvency risk. The three pillars of the Luxembourg financial collaterals: (i) Non-formalistic implementation; (ii) Contractual freedom; and (iii) Protection against the pre-insolvency and/or insolvency riskLuxembourg Financial Collaterals 28 | P a g e
  29. 29. THE TWO-TIER LUXEMBOURG SECURITY PACKAGETHE FRAMEWORK: CREATING A FULL LUXEMBOURG SECURITY PACKAGE  The Pledgor and the Pledged Third Party are Luxembourg EntitiesSetting up a two-tier Luxembourg structure - LuxCo 2 being a 100% owned subsidiary of LuxCo 1 –ensures that the pledgor and the pledged third party are both Luxembourg entities.The requirement of having LuxCo 1 being a Luxembourg entity is of a prominent importance in thelight of the pre-insolvency or insolvency measures which may possibly apply to that entity.Only pre-insolvency or insolvency measures ordered by Luxembourg courts may give full comfort tothe pledgee that the full effect against pre-insolvency or insolvency risk of the pledgor, as set out bythe Law on Financial Collateral Arrangements, will be recognized and given full force and effect. Onthe other hand, pre-insolvency or insolvency measures ordered by non-Luxembourg courts potentiallyhave the risk that the protection of the pledgee’s rights under the Law on Financial CollateralArrangements may be set aside by foreign courts. It may not be conclusively anticipated that foreigncourts, taking their capacity and power from the EU Regulation 1346/2000 relating to internationalinsolvency proceedings, will necessarily accept the prevalence of the Law on Financial Collateralsover the strong powers conferred to them by the EU Regulation 1346/2000.  All Pledged Assets are Located in LuxembourgIt is also important that all pledged assets are located in Luxembourg.That requirement is two-fold. First of all, financial collaterals under the form of pledges beingessentially rights in rem, the law of the situs of the pledged assets governs, according to privateinternational law principles, in particular:  Which assets or type of assets may be pledged;  Conditions of dispossession of the pledged assets;  Perfection requirements of the pledge vis-à-vis third parties, most notably vis-à-vis the legal entity which issued the pledged assets (LuxCo 2), as well as to the depositors of the pledged assets (account banks);Secondly, the location of the pledged assets is of primary importance in respect of insolvency matters.Pursuant to EU Regulation 1346/2000 relating to international insolvency proceedings, the jurisdictionwhich is competent to open the main insolvency proceedings and to have such proceedings governedby the law of that jurisdiction applies, as a matter of principle, to all of the assets of the insolventcompany, wherever the assets may be located (principle of universality of the insolvencyLuxembourg Financial Collaterals 29 | P a g e
  30. 30. proceedings). However, the EU Regulation 1346/2000 reserves, at certain conditions, the jurisdictionof the courts of other members States (secondary insolvency proceedings) in respect of assets whichare located in such other members States. The attraction of the law of the situs justifies suchderogation to the universal character of the main insolvency proceedings. It may not be excluded thatthe secondary insolvency proceedings opened in such other member States may have as effect tolimit the full recognition and efficiency of Luxembourg financial collaterals.The Luxembourg two-tier structure ensures that all assets pledged by LuxCo 1 are effectivelyregarded as being located in Luxembourg:  LuxCo 2 shares and the hybrid instruments issued by LuxCo 2 are registered at the Luxembourg registered office of LuxCo 2;  The receivables owed by LuxCo 2 are deemed to be located at the registered office of LuxCo 2, in its capacity as debtor of the receivables; and  The LuxCo 1 bank accounts are deemed to be located where the accounts are held.THE PURPOSE: ENSURING THE FULL EFFICIENCY OF THE ENFORCEMENTPROCESSIt is at the time of enforcement that guarantees do evidence their value. At that criticalmoment, it is of a paramount importance that the enforcement proves straightforward andefficient.  The Breach of any Contractual Obligation Allows to Enforce the PledgeThe Law on Financial Collaterals gives full effect to contractual freedom. The parties are free todetermine any event of default, not necessarily a payment default, triggering the enforcement of thepledge. By providing that no acceleration – or at least not full acceleration – of the underlying debt isrequired to enforce the pledge, the Law on Financial Collaterals goes further than the Directive onFinancial Collateral Arrangements.The Law on Financial Collaterals departs from the classical concept of the security as an accessoryof the secured debt’s repayment.Luxembourg Financial Collaterals 30 | P a g e
  31. 31.  The Full Scope of Enforcement MeasuresThe Law on Financial Collaterals allows the pledgee to enforce a pledge according to the followingenforcement measures:  Appropriation of the assets, by the pledgee or a third party, at the price determined, before or after the appropriation, in accordance with the valuation method agreed between the parties1;  Sale of the pledged assets by way of a private sale (vente de gré à gré);  Sale of the pledged assets by way of a sale in a stock exchange;  Sale of the pledged assets by way of a public auction;  Request a court to order that the pledged assets will be kept by the pledgee as payment, up to his secured debt, further to an estimate conducted by an expert;  Proceed to a set-off; or  In respect of financial instruments, appropriate the financial instruments at their current stock exchange price or, in respect of UCITs’ shares, at their latest published NAV.The above list of authorised enforcement measures reflects the strong willingness of the Luxembourglegislator to implement all enforcement measures which were encompassed within the Directive onFinancial Collateral Arrangements. In particular, implementation into national legislation of theappropriation measures was merely optional for the EU Member States.  A Non-Formalistic Enforcement ProcessTime is of the essence in the enforcement process. Any delays, additional formalities, interventionsof public or judicial authorities are undoubtedly detrimental to the pledgee’s interests. Whiletransposing the Directive on Financial Collateral Arrangements into Luxembourg law, theLuxembourg legislator was therefore determined to eliminate as much as possible any hurdles inthat respect.1 The right granted to a third party to appropriate the pledged assets, as well as the right to appropriate before completion ofthe valuation process, were expressly confirmed by the law of 20 May 2011.Luxembourg Financial Collaterals 31 | P a g e
  32. 32.  The “No-Notice” Principle Enforcement is allowed without having to give any prior notice to the pledgor. This is to avoid, by giving him warning, the pledgor’s being tempted to disguise the pledged assets or take any preventive counter-measures which may slow down or jeopardise the enforcement process. No further notice is in principle required to the depositor of pledged assets (e.g. a bank, in respect of the pledged bank accounts) or vis-à-vis the issuer of the pledged assets (LuxCo 2).  Derogation from the Luxembourg Corporate Law Principles for Enforcement in Sàrl’s The enforcement of pledged shares of a Sàrl raised a specific issue which has been addressed by the Law on Financial Collaterals. Pursuant to Luxembourg corporate law, any transfer of shares of a Sàrl to a party which is not a current shareholder is subject to the prior approval by a qualified majority of shareholders which may not be given in advance. This prior shareholders’ approval is due to the closed character of the Sàrl. Although justified from a corporate law perspective, this requirement was obviously a major cause for discomfort to the pledgee. The Law on Financial Collaterals provides that in case of enforcement, in full or in part, by transfer of shares of a Sàrl, the prior approval of the shareholders is not required if the pledge applies to all the shares issued. In case the pledge does not to apply to all the shares issued, the prior approval may be given at any time prior to the enforcement and that prior approval is irrevocable.  The Private Character of the Enforcement Measures With three exception (sale in a stock exchange, sale by public auction, and court order that the pledged assets will be kept by the pledgee as payment) enforcement procedures do not require the involvement of public authorities. This saves time and money. Enforcement measures are not subject to any taxes or registration duties.  Full immunization effect of the enforcement measures against the pre-insolvency or insolvency riskAs a reminder, one main concern of the Luxembourg legislator while enacting the Law on FinancialCollateral Arrangements was to protect the pledgee’s rights against the pre-insolvency and insolvencyrisks at the level of the pledgor and pledged third party.Luxembourg Financial Collaterals 32 | P a g e
  33. 33. In that respect, Article 20 (1) of the Law on Financial Collateral Arrangements expressly states thatfinancial collateral arrangements, as well as the facts triggering the enforcement thereof, are valid andenforceable vis-à-vis third parties, commissars, curators, receivers, liquidators or other similar organsnotwithstanding any Luxembourg or foreign pre-insolvency or insolvency measures. That coreprinciple is repeatedly stated in several other provisions of the Law on Financial CollateralArrangements and was given full effect by the Luxembourg courts which qualified this principle as aloi de police. ENFORCEMENT OF LUXEMBOURG FINANCIAL COLLATERALS: MAIN FEATURES  Breach of any contractual obligation allows enforcement; a pledge is no longer linked to debt  Choice of enforcement measures  Enforcement is not burdensome  Enforcement is not subject to taxes or other duties  The enforcement fully benefits from the immunisation effect against the pre- insolvency or insolvency risk of the pledgorLuxembourg Financial Collaterals 33 | P a g e
  34. 34. LUXEMBOURG FINANCIAL COLLATERAL PRACTICE: LESSONS OF THEFINANCIAL CRISISDEBT RESTRUCTURING: A RESISTANCE TEST FOR THE LUXEMBOURGFINANCIAL COLLATERALSNot unsurprisingly, since the outbreak of the financial crisis in early 2008, an increasing number ofdebt restructurings have necessitated the enforcement of Luxembourg financial collaterals. Theseenforcement measures took place in the context of either consensual or non-consensual debtrestructurings. In the latter cases, the dissenting interests between the different lenders to thesyndication generated tensions which required from the legal counsels involved a particular expertisein that field. More generally, the severe crisis situation at the level of the target group – over-indebtedness, actual threat on thousands of workers’ jobs, direct or indirect intervention of worriedpublic authorities (states, regions), media focus –justified that such debt restructurings, including theLuxembourg financial collaterals’ enforcement process, be conducted cautiously.The enforcement exercises were a first in Luxembourg. As a result, the Luxembourg practitioners didnot benefit from the experience of previous similar transactions and were exposed to a number of newlegal issues. It can be therefore regarded of some interest to expose some of those issues, togetherwith the solutions which have been explored so as to respond those issues. The Luxembourg case-law also proved instrumental in that respect.THE ENFORCEMENT OF THE LUXEMBOURG FINANCIAL COLLATERALSEXERCISES PROVED THEIR EFFICIENCYBefore examining the specific legal issues raised by enforcement exercises, it must bestressed that the Luxembourg financial collaterals successfully passed the enforcement test.One of the most notable features of the Luxembourg financial collaterals, namely their non-formalisticcharacter, provided its full benefit. The enforcement of the whole set of Luxembourg pledges was completed in a couple of hours, all notices, if any, having been duly served, all relevant registers (share register, etc.) having been duly amended and, last but not least, all pledged assets having been legally transferred to their new owner(s).In most cases, the enforcement measure used was the private sale made at normal commercialconditions. In addition to the fact that such enforcement measure is privately conducted and thereforedoes not require the intervention of any public authorities (courts, stock exchange), the securitytrustee is not eager to favour the appropriation of the pledged assets, even for a second.Luxembourg Financial Collaterals 34 | P a g e
  35. 35. LEGAL ISSUES RAISED BY THE PRIVATE SALE MADE UNDER NORMALCOMMERCIAL CONDITIONS  The Concept of “Normal Commercial Conditions”  The issue: the law is silentThe condition and concept of “normal commercial conditions”, as referred to by the Law on FinancialCollateral Arrangements in relation to the private sale’s enforcement measure, is not defined by law.This legal vacuum raised a notable issue, given that a violation of that condition may call into questionthe validity of the sale.  The practice interpretationDue to the initial absence of judicial precedents at the time, practitioners rapidly came to a firstconsensus: “normal commercial conditions” may not be necessarily interpreted as relating to a normalmarket situation. The specific downgraded economic and financial situation at the level of the targetgroup may justify that the sale price may be soundly affected thereby.In practice, the question was to determine the method of the sale price. Several ways may beconsidered. Organising a private auction may be considered and that way may be regarded as closelyresponding to the requirement of creating the conditions of a real market. However, the practicaldownside of an auction sale may not be overlooked, either in terms of cost, confidentiality, realefficiency concern in the context of a most deteriorated situation of the target group, as well as interms of time required. Indeed, in such debt restructuring situations, time is of the essence of thesuccess and having a private auction settled, with burdensome notice requirements, may jeopardisethe fair achievement of the whole restructuring process.A more efficient and reasonable modality of determining the sale price according to the normalcommercial conditions’ criterium was found in asking an independent reputable audit firm to determinethevaluation of the pledged assets. The audit firm will conduct the valuation according to its highestprofessional standards pursuant to an in-depth economic and financial analysis.  The case-law confirmationThe practice’s analysis was massively comforted by a judgment of 20 May 2010 rendered by theDistrict court of Luxembourg. Pursuant to this decision, the concept of “normal commercial conditions”corresponds to “the best offer to take into consideration is the offer available in the conditionsapplicable to the assets at stake”. The interpretation by the court clearly favored an in concretointerpretation of the concept of “normal commercial conditions”. In addition, the court emphasized thatthe Law on Financial Collateral Arrangements does not even require from the pledgee to conduct anindependent valuation of the pledged assets before being entitled to enforce the pledge.Luxembourg Financial Collaterals 35 | P a g e
  36. 36.  The Concept of “Sale”Under which form the purchaser must pay the price can raise difficulties. Must the price be under theform of a monetary amount only or is the purchaser entitled to pay in kind? That question arose in thecontext of enforcement exercises in which it was contemplated that the seller may receive Payment InKind Notes in payment for the sale of the pledged assets. Does such a mode of payment still relate toa sale or is there a risk of requalification of the sale into an exchange? In the latter case –requalification as an exchange - is there a risk of having the enforcement proceedings declared invalid,given that the exchange is not part of the enforcement measures set forth by the Law on FinancialCollaterals?On that particular issue, no firm consensus exists. As a result, any conservative approach should bereluctant in admitting a payment for the purchased assets other than in the form of a monetaryamount, either by immediate or postponed payment.THE LITIGATION RISKIn the context of enforcement measures by which investors are utterly deprived of the controlof the target group, further litigation risk must be considered seriously. It must also be takenas seriously in the context of non- consensual restructuring exercises whereby some juniorlenders may be excluded from the restructuring lenders’ syndication and their return oninvestment expectations may be massively, impacted. In any case, the litigation risk shouldnot be overlooked. However, Luxembourg courts clearly favor legal safety and the fullefficiency of the financial collateral arrangements.  The Two-Folded Litigation Risk: Main Proceedings / Summary Proceedings  Main proceedingsLimited Scope of Luxembourg Main ProceedingsAs a matter of principle, main proceedings initiated in relation to the enforcement of Luxembourgfinancial collaterals should have a scope limited as to the verification by the Luxembourg courts thatthe conditions of enforcement were fully complied with. In the context of enforcement measures underthe form of private sales, the courts shall mainly verify that: - the enforcement was in conformity with the contractual facts and circumstances duly triggering the enforcement of the financial collaterals; and that - the sales were made at normal commercial conditions.Luxembourg courts should not have jurisdiction in respect of the legal issues in relation to thefinancing documentation (Facility Agreement, Intercreditor Agreement), given that those documentsare generally governed by a law other than Luxembourg law and that jurisdiction clauses giveexclusive jurisdiction to the courts of the governing law state. However, it must be checked in eachcase whether such exclusive jurisdiction applies to all parties or only to some of them (borrower). Inthe latter case Luxembourg courts may also have jurisdiction in respect of the financing documents.Luxembourg Financial Collaterals 36 | P a g e
  37. 37. Effects of Luxembourg Main ProceedingsIf the enforcement of the financial collaterals was not made in conformity with the contractual factsand circumstances duly triggering the enforcement of the financial collaterals, or that the sales werenot made at normal commercial conditions, the question arises as what effect such a decision has.The question is whether the courts may order the quashing of the enforcement, proceedings oralternatively, may only grant damages. A risk of having the decision reduced would clearly be a causeof major concern for the parties involved in the enforcement process given, that it would jeopardisethe whole debt restructuring process. Although the Law on Financial Collaterals is not clear in respectof that major issue, it was generally interpreted as permitting only the granting of damages. Thisanalysis was confirmed by the aforementioned judgment of 20 May 2010: “The sanction of the non-respect of selling the pledged assets at normal commercial conditions is not the nullification of thesale yet is under the form of damages”.  Summary proceedings: Strict Limitations Set Forth by Luxembourg CourtsAccording to Whereas 17 of the Directive on Financial Collateral Arrangements, judicial control of theenforcement measures should be restricted to post-enforcement. That judicial restraint is in line withthe general trend of the directive aiming to eliminate, to the possible extent, any obstacles whichwould impair the full efficiency of the financial collaterals. In that respect, EU Member states’ courtsshould refrain from admitting their jurisdiction in the context of ex-ante summary proceedings, bywhich the claimants would attempt to slow down the enforcement process.However, once enforcement proceedings have begun, it may not be excluded that, in the furtherperspective of main proceedings, claimants may be tempted to take advantage of swift summaryproceedings. The purpose of such summary proceedings is to have the enforcement effects frozen orthe assets put in escrow until the claim is ruled as to the merits in the course of further mainproceedings.This important topic was dealt with by the Court of appeal in Luxembourg (3 November 2010):pursuant to a judgment which may be regarded as a case-law precedent, the court expressly ruled outthat judicial freezing provisional measures further to enforcement are not permitted. This paramountdecision is a strong support for legal safety which is at the core of the Law on Financial CollateralArrangements.  The Luxembourg case-law: a strong support for full efficiency of the financial collateral arrangements The current trend of the Luxembourg case-law clearly favors legal safety. In all circumstances so far where Luxembourg courts were requested to make interpretations on the Law on Financial Collateral Arrangements, their decisions proved to give a strong judicial support for the full efficiency of the financial collateral arrangements, in particular in respect of the critical phase of their enforcement.Luxembourg Financial Collaterals 37 | P a g e
  38. 38. THE PRE-INSOLVENCY AND INSOLVENCY RISKAs detailed above, the Luxembourg two-tier structure set up in accordance with the Law onFinancial Collaterals fully provides immunization against the pre-insolvency and insolvencyrisk. However, in order to escape the insolvency immunization, some may try to transfer thecentre of main interests (COMI) of LuxCo 1 and LuxCo 2 to a jurisdiction which does notrecognise that immunization, with the detrimental effect of jeopardising the efficiency of theLuxembourg financial collaterals. For the purpose of neutralising such escape attempts,counter-measures must then be considered.  Risk of Transfer of the COMIThe COMI is determined pursuant to factual elements The concept of COMI is instrumentalsuch as the place where corporate decisions are taken or in the context of the EU Regulationthe place from where the corporate entity is effectively 1346/2000 relating to internationalmanaged. The concept of COMI is therefore very close to insolvency proceedings, as thethe real seat doctrine, which is applied in Luxembourg law. location of the COMI determines theThe COMI or the real seat are determined pursuant to a jurisdiction and the governing law ofrange of factual elements: place of holding of the board the insolvency proceedings.meetings, place of holding of the shareholders’ meetings,place where the books of the company are kept, placewhere the accounts of the company are drawn up. As a result, the COMI may be regarded as havingbeen transferred to another jurisdiction if one or several of these elements are located in thatjurisdiction. The COMI doctrine would seem to allow forum shopping.In parallel, there may also be a risk that the pledged assets be transferred to the same foreignjurisdiction. Pursuant to the EU Regulation 1346/2000 relating to international insolvency proceedingsthis would mean that those assets would be part of the assets subject to the main insolvencyproceedings opened in that jurisdiction. On the other hand, the pledged assets are regarded as stillbeing located in Luxembourg, such assets would not be subject to main insolvency proceedings andsecondary insolvency proceedings should be opened in Luxembourg in respect of those specificassets. In that case, the Luxembourg court having jurisdiction over such secondary insolvencyproceedings will fully recognise the waterproof effect of the Luxembourg financial collaterals.In the context of the contemplated enforcement Luxembourg financial collaterals and with theintention of escaping the Luxembourg law insolvency waterproof effect, the transfer of the COMI hasbeen successfully performed in the famous Coeur Défense case: the French court admitted that thecompany, which had its registered office in Luxembourg, actually had a French COMI and thereforefiled the company under the protective French mesures de sauvegarde, which meant that the pledgeewas no longer allowed to enforce his Luxembourg financial collaterals.The risk of transfer of the COMI and of the pledged assets out of Luxembourg is real and it may havedevastating effects in respect of the enforceability of Luxembourg financial collaterals.Luxembourg Financial Collaterals 38 | P a g e
  39. 39.  Counter-MeasuresAmong a series of counter-measures aiming at preventing the risk of transfer of the COMI out ofLuxembourg as the main measures should consist in giving to the Luxembourg entity as much assubstance as possible. Whilst the substance is well-known to tax practitioners, it was somewhatoverlooked in terms of the security package and that concern must be therefore seriouslyreconsidered. To some extent, the substance package shall be examined and decided on a case-by-case basis and relevant substance elements will therefore be recommended.In respect of the risk of transfer of the pledged assets out of Luxembourg, efficient counter-measuresmay also be considered, such as the registers (shares, bonds, hybrid instruments, receivables) held inescrow in Luxembourg.Luxembourg Financial Collaterals 39 | P a g e
  40. 40. CONTACTLuxembourg Financial Collaterals 40 | P a g e
  41. 41. Daniel BOONE, Partner David MARIA, Director Daniel Boone is a partner at Wildgen David Maria is a director at Wildgen, Corporate and Finance Department, specialising in corporate and tax law actively involved in international M&A matters. deals and major debt restructuring transactions in which he provides his Prior to joining Wildgen, David worked sound corporate law, civil law and with prominent law firms and “Big 4” in collaterals’ law expertise. Luxembourg and London where he gained sound experience working on Daniel is the author and editor-in-chief tax planning, international taxation and of numerous publications on the topics corporate law matters. David also of corporate law, financial collaterals, collaborated with tax authorities on tax contractual law and anti-money agreements. He is a member of the laundering matters. Daniel is a lecturer International Fiscal Association and of (chargé de cours associé) in corporate the Association luxembourgeoise law at the University of Luxembourg. d’Etudes Fiscales. Spoken languages: Spoken languages: French, English French, English, German Contact: Contact: david.maria@wildgen.luLuxembourg Financial Collaterals 41 | P a g e
  42. 42. Luxembourg Financial Collaterals 42 | P a g e
  43. 43. The Moneychanger and his Wife, 1514 By Quentin Massys (1466 – 1530) Louvre, ParisThe information contained herein is of a general nature and is not intended to address the circumstances of any particularindividual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that suchinformation is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act uponsuch information without appropriate advice after a thorough examination of the particular situation. Therefore, WILDGEN cannot accept any liability for any errors, omissions or opinions contained herein and for the implementation of the principles set outwithout its active involvement.
  44. 44. Established in 1923 69, boulevard de la Pétrusse L-2320 Luxembourg Tel.: +352 40 49 60 1 Fax: +352 40 44 09 www.wildgen.luAvocats à la Cour