Two broad themes are currently emerging in relation to European
private equity real estate financing.
First, market commentary has noted that
€150 billion of this finance is due to mature by 2025 –
the “wall of credit”.
Secondly, the recent trajectory of rising interest rates, and
likely continuance of a new interest rate norm materially higher
than rates prevailing in recent years, is likely to lead to
increased pressure on current interest-cover financial covenants
and therefore ultimately debt servicing. It is also possible that
market correction in real asset valuations plus a tightening credit
environment separately contribute to pressure on loan-to-value
norms.
In conjunction with this need to refinance and / or to address
increasing pressure on financial covenants of existing structures
over the coming months, three options are likely to present
themselves to sponsors and finance parties:
- increase equity investment, possibly through preferred
stock - introduce second ranking credit, such as second lien, stretched
mezzanine finance or PIK financing, and / or - realise investments, whether on a voluntary or enforcement
basis.
The latter will be of interest both to secured finance parties
seeking to obtain repayment through security enforcement and their
asset-purchase counterparts, but also to special situations /
tactical opportunity investors in secured, non-performing loan
portfolios.
Given the inherently multi-jurisdictional character of
cross-border investment and its related financing, prior to
implementing any such actions, a thorough review of the efficacy of
existing security and the relative merits of enforcing at different
levels of the holding structure will be apposite.
In many cases, this analysis will bifurcate between either
enforcement at the level of the real assets themselves or at the
level of security over the holding structure. The merits of either
approach will include account of the available enforcement methods,
speed of execution, risk, degree of Court / insolvency
office-holder / other third party involvement and costs under the
respective options.
European PERE – simplified structure
Options
The secured collateral at the level of the real assets, governed
in each case by the applicable law of (or applied by) each
relevant, portfolio jurisdiction could include: real estate
mortgages or hypothecs; charges or pledges over bank accounts,
insurance claims, hedging arrangements, receivables and other book
debts; plus in relation to operating businesses, intellectual
property, fixtures and fittings and goodwill.
In contrast, at the Luxembourg holding structure level, the
secured collateral in the context of cross-border, private equity
real estate investment, typically comprises: shares in Luxembourg
holding companies; the Luxembourg bank accounts of such companies;
and intra-group debt financing receivables payable by such
companies and / or governed by Luxembourg law (Luxembourg
holding collateral).
All such collateral will be secured under a single applicable
law and will provide a single point of enforcement to take control
of all capital value in, and income deriving from, the downstream
structure – provided the secured lender also holds first
ranking security with structural priority at the asset level, to
avoid being precluded from access to that value by a competing
creditor with security at the level of, or at least closer to, the
real assets.
Although a variety of Luxembourg corporate, limited partnership
and alternative investment vehicles exist, the vehicles most widely
used in such holding structures are sociétés
à responsabilité limitée
(Sàrl), which are private, limited
liability companies. This briefing refers to interests in or held
by such Sàrl and to security over the entire issued share
capital, rather than over a limited proportion only, as is market
norm in these structures.
Luxembourg security
The security over this Luxembourg holding collateral will
typically take the form of a pledge, governed by Luxembourg law,
under the Luxembourg Financial Collateral Law 2005
(Financial Collateral Law). The alternative, but
less widely used security interest, available under the Financial
Collateral Law is an assignment by way of security.
Both provide real, proprietary security interests. The
difference is that the assignment by way of security transfers
ownership of the secured collateral to the secured party at the
creation of the security interest (subject to an obligation of
re-transfer on discharge). In contrast, the pledge does not
transfer ownership to the secured party at the creation of the
security interest, ownership remains with the pledgor but subject
to the pledgee’s various rights, including the right to
appropriate the asset on any subsequent enforcement.
The Financial Collateral Law was enacted with the express
legislative policy of providing enhanced usability for secured
financing of investment structures. This forms the continuing
judicial policy in this area.
As a result, the creation of valid security interests,
enforceable against potentially competing third parties (whether
other creditors or insolvency office-holders) is straightforward.
Security can be created over both present and future collateral
pursuant to a written pledge agreement.
In the case of pledges over shares issued by a Sarl, perfection
is achieved by joining the Sarl to the pledge agreement (by way of
notice and acknowledgement) plus the notation of the creation of
the pledge by the Sarl on its internal share register. Similarly,
pledges over intra-group financing receivables are perfected by
joining the obligor of those receivables to the pledge agreement by
way of notice and acknowledgement. In relation to bank accounts,
notice of the pledge, and acknowledgement of that notice, need be
exchanged with the relevant account bank. In practice this will be
done on the standard documents of the particular account bank.
No public registration, filings or notarial involvement in
Luxembourg is required or relevant. Nor is any stamp duty or
similar transfer tax levied by Luxembourg on such transactions.
Collateral usage
The Financial Collateral Law recognises the validity of
contractual flexibility for the parties as regards the usage of the
secured collateral during the existence of the pledge, prior to any
enforcement. The parties are therefore free to agree to whatever
usage, by either of them, is commercially appropriate, without this
impacting on the validity of the security interest in any way.
In relation to share pledges, standard market practice is
therefore for the pledge agreement to provide that voting rights
attaching to the collateralised shares are exercisable by the
pledgor until the occurrence of a continuing event of default. From
that time, it is usual to provide that the right to exercise such
voting rights vests in the pledgee only, although variations on
this theme are seen from time to time.
Events of default
The events of default which may trigger enforcement action are
also a matter of contractual flexibility and will be agreed as
appears commercially appropriate to the parties at the time of
entering into the financing. In practice these events of default
are often incorporated into the pledge agreement by reference to
the credit facility agreement. It is therefore possible, to agree a
range of events which may constitute a default, presenting the
option of enforcement.
Security enforcement
Following the occurrence of a relevant event of default, the
availability to the secured party of enforcement action is also a
matter of contractual flexibility to be agreed between the parties.
It is standard to cross-refer to the occurrence of a continuing
event of default as set out in the credit agreement. There is no
statutory requirement to accelerate the underlying secured
obligations prior to enforcement. However, the secured parties’
duties (please see below) do require enforcement to be effected in
good faith and for the purpose of repaying the secured obligations,
which is likely to imply acceleration at an appropriate time.
Whilst the parties may decide to agree contractual cure periods,
possibly tailored to the varying seriousness of specific types of
default, there is no statutory cure or “grace” period at
law. Nor is there any applicable statutory moratorium on
enforcement of security interests under the Financial Collateral
Law. Standard market practice is to disapply any requirement for
prior notice to the pledgor (or any other party), although in
practice it may often be appropriate to make written demand on all
transaction obligors in respect of all available primary payment
obligations as well as guarantees under all applicable laws.
The standard mechanisms of enforcement include:
- private appropriation of the secured collateral, either to the
secured party or to a third party - private sale of the secured collateral under “normal
commercial conditions” - public sale / auction under the aegis of the Luxembourg stock
exchange, appropriate in relation to listed securities - court-ordered transfer of title, and / or
- set off against the secured obligations.
In practice, private appropriation and /or private sale are the
most frequently utilised mechanisms. Both are out-of-Court
mechanisms carried out directly by the secured party, not through
the agency of a receiver, administrator or similar officer.
In practice, appropriation of secured shares or receivables
collateral is effected by written notice to the underlying company.
Such notice constitutes the transfer of title to the collateralised
shares and receivables without requiring further action by or on
behalf of the underlying company (or any other party). From that
time, title to the collateralised shares vests in the secured party
who is then able to exercise all associated shareholder voting
rights, including to change the composition of the board of
directors of the underlying company. The new board, appointed by
the secured party will then exercise control over the business and
assets of the company (subject to the secured parties’ other
security) and therefore indirectly over all assets held downstream
in the structure.
It is usual to provide contractually that such private
appropriation or private sale must be at the fair market value of
the collateral. Market norms are that such valuation be carried out
by an independent, external and statutorily approved auditor,
appointed by the secured party, and applying a standard
multi-criteria valuation methodology under a recognised set of
accounting principles (either IFRS or, if different, the most
relevant, generally applied accounting principles). A variation on
this theme may see an investment bank act as the independent
valuer, which may be relevant in the rare cases of enforcement over
listed securities.
Valuation may be carried out either prior to, or following
appropriation (or sale), albeit with effect as at the time of
appropriation (or sale). Valuation following appropriation will
often allow expeditious action to take control of the structure,
followed by valuation at a more methodical pace and with the
benefit of access to the books and records of the company whose
issued shares are collateralised, resulting in a better informed
valuation.
Similarly, appropriation of secured bank accounts is effected by
written notice to the account bank, blocking any further usage of
the secured account(s) by the pledgor and notifying the account
bank that usage of the balance credited to the secured account(s)
now lies exclusively with the pledgee.
As in respect of the creation of the pledges, no public
registration, filing or notarial involvement is applicable. Nor is
any stamp duty or similar transfer tax applied in Luxembourg.
Duties and protections
Good faith is a duty on the parties, implied by law in relation
to all Luxembourg contracts, including pledge agreements. This duty
applies to pre-contractual negotiations, contractual performance
and to enforcement by the secured parties. In addition, enforcement
by private sale must occur on “normal commercial
conditions” and any enforcement whose sole intention is to
cause harm to the pledgor would constitute a breach of duty on the
part of the secured party.
The other principal protection for the pledgor (and any other
creditors of the pledgor’s estate) is the contractual fair
valuation duty, carried out by an independent, expert valuer
according to generally applicable accounting principles, noted
above. If the valuation is subsequently found to be inadequate on
complaint to the court, the remedy is damages payable by the
secured party, not revocation of the enforcement action.
Market norms are for the pledge agreement to provide contractual
protection for the secured party from any liability occasioned by
the exercise of powers under the pledge agreement, provided such
powers are exercised without fraud, gross negligence (faute
lourde) or wilful misconduct.
In relation to the enforcement of share security, the underlying
company and its directors will be on notice of the share pledge and
the pledge should be notated on the company’s share register
(with a copy of that updated register being provided as a condition
of closing the original financing transaction). Following
notification of appropriation on enforcement by the secured party
(or sale to a third party), non-compliance with such notification
by or on behalf of the underlying company may risk liability in
delict, the Luxembourg law equivalent of tort in English
law.
Priority over insolvency procedures
Security interests validly created under the Financial
Collateral Law prior to the commencement of any insolvency
procedure under either Luxembourg law or non-Luxembourg law, are
enforceable in Luxembourg against the insolvency officeholder. In
the absence of fraud, there are no applicable security
“hardening periods” in respect of security interests
under the Financial Collateral Law. Under generally applicable law,
such “hardening periods” do exist but are disapplied by
the Financial Collateral Law from security interests created under
it.
Under the EU Insolvency Regulation, security interests validly
created under the law of one EU member state are automatically
recognised and accorded priority in insolvency proceedings
commenced under the law of any other EU member state. The
Insolvency Regulation does apply in relation to non-EU member
states.
Secured collateral under the Financial Collateral Law is
excluded from the pledgor’s insolvency estate, although in
practice, it may be advisable to act expeditiously to establish
practical control over the collateral prior to any such appointment
being made.
Disapplication of insolvency set-aside risk
Under Luxembourg law, the starting point is certain transactions
entered into between the onset of effective cashflow insolvency and
any subsequent commencement of an insolvency procedure may be at
risk of being void and / or set aside on an application to the
Court. The maximum period of risk is generally up to six months
prior to the commencement of insolvency proceedings.
However, in the absence of fraud, all such set aside risks are
disapplied by the Financial Collateral Law from security interests
created under it.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
