This publication was drafted by the LPEA committee "Financings in Private Equity of the LPEA" under the coordination of Constantin Iscru (DLA Piper) and is based on the contributions of Natalja Taillefer (Loyens & Loeff), Nicolas Widung (Bonn Steichen & Partners), Dominik Pauly (Arendt & Medernach), Tiago Ventura Mendes (Linklaters) and also includes contributions from Delphine Gomes (AKD), François-Guillaume de Liedekerke (Allen & Overy) and Ana Bramao (Elvinger Hoss Prussen).
In the aftermath of Brexit, there was an opportunity for European jurisdictions to attract a significant part of the financial activities and actors which for a significant part were based in the UK and particularly the City of London. With the UK out of the EEA, the headquarters of many financial institutions for the European market had to be moved and the benefits of the use of English law and courts were considerably reduced. In the most optimistic (for continental Europe) scenarios, most of the financial activities from London will have been absorbed by other European financial hubs. Among these, Luxembourg, while not backed by a large scale economy, was well positioned and Luxembourg law presented sufficient promise for increasing its importance in the context of European and international transactions.
Two years later, the windfall for Luxembourg was significant, but clearly not at the higher levels hoped by Luxembourg stakeholders. Particularly as concerns the use of Luxembourg law on international transactions, most Luxembourg law firms have seen an uptick in its use on transactions conducted through Luxembourg, particularly when involving Luxembourg alternative investment funds and their financings while EU institutions, the European Investment Fund and the European Investment Bank have switched in several areas from English to Luxembourg law as governing law for their legal documentation.
The success of Luxembourg law rules for financings is centred on the Luxembourg law of 5 August 2005, as amended on financial collateral arrangements ("Financial Collateral Law"), which provides rules for security interests over assets located in Luxembourg, with key advantages such as insolvency remote security interests, flexible (out of court) and swift enforcement options and legal certainty, with a stable legal framework and consistent case-law and mature market practice. The Financial Collateral Law is a cornerstone of the Luxembourg legal financial framework and one of the reasons for the attractivity of Luxembourg as a jurisdiction for cross-border financing transactions. The choice of Luxembourg law as governing law of main financing agreements, such as loan agreements, is still marginal and is presumably also held back by the lack of compatibility of the applicable rules on compounding of interest with business needs and the absence of market-standard templates of finance documents and of a full recognition of agents and trustees.
The reasons for this only limited progress are complex: the success of a particular national law is built over time and depends not only on the inherent features of that law, but also on other factors, such as its stability and predictability and the case law and the expertise of legal professionals applying it. While some of this is due to shortcomings of Luxembourg law, at least a part can be attributed to a yet insufficient awareness of international actors (including those based in or conducting business through Luxembourg) of the full range of features already available under, or recently implemented in Luxembourg law. The purpose of this publication is to contribute to increase such awareness and underline the continuous effort made for expanding the Luxembourg legal tools available, while also highlighting the areas where progress could still be made.
Since 2020, several measures have enriched the Luxembourg law's legal arsenal for international financings, such as the introduction of the professional payment guarantee, the clarification of the rules on financial assistance for SARLs, the reform of the rules applicable to covered bonds and the update of the Financial Collateral Law, while the reform of the bankruptcy law and of the rules on compounding of interest are still to be implemented.
Introduction of the professional payment guarantee
The law relating to professional payments guarantees was adopted on 10 July 2020 and brought with it a new contractual based personal guarantee to the Luxembourg legal framework. This new type of guarantee – that is already used and is expected to be used more often by market players in international and Luxembourg domestic financings – gives contractual flexibility and legal certainty, allowing parties to tailor its terms according to their specific needs and combine (or exclude) features of suretyships (cautionnement) and independent guarantees. Combining features from both regimes was risky if not unconceivable in the past because it entailed a risk of re-characterisation of the independent guarantee into a suretyship.
The guarantor can be any person (e.g. individual or corporate entity) and the professional payment guarantee can be granted in favour of one or multiple creditors or to an agent representing such creditor(s). The guaranteed claims can be of any nature, present or future and the professional payment guarantee can also be issued to guarantee any risks associated with any type of claims and at the request of beneficiary or a third party (e.g. the debtor of the guaranteed claims).
The parties have the freedom to contractually agree on the conditions under which the professional payment guarantee may be called. This means that the occurrence of the risk guaranteed or a default under the relevant guaranteed claims, as well as an acceleration and cancellation thereof, may not be required to call the guarantee. Another protective feature is that, unless contractually agreed otherwise, the guarantor remains liable to the beneficiary for all the guaranteed obligations even if the debtor of the guaranteed claims is subject to a reorganisation measure, insolvency proceedings or other similar proceedings (without prejudice to the Luxembourg rules on over-indebtedness in case the debtor is an individual). It is worth noting that these features are similar to features existing under the Financial Collateral Law.
Financial institutions will be able to make use of the new professional payment guarantee as eligible unfunded credit protection for the purposes of Regulation (EU) No. 575/2013.
Clarification of the non-applicability of financial assistance restrictions to SARLs
The Luxembourg law of 6 August 2021 has finally clarified that the financial assistance restrictions set forth in article 430-19 of the Luxembourg law of 10 August 1915 on commercial companies (Companies Law) do not apply to Luxembourg private limited liability companies (SARLs) by removing the reference to SARL shares (parts sociales) from article 1500-7 paragraph 2 of the Companies Law (which, inter alia, provides for criminal sanctions for directors of companies who participate in unlawful financial assistance schemes). Prior to the adoption of the law, there was uncertainty among practitioners in Luxembourg whether the restrictions applicable to Luxembourg public limited liability companies (sociétés anonyme) and corporate partnerships limited by shares (sociétés en commandite par actions) to provide financial assistance, i.e. advance funds, provide security interests or extend loans with a view to the acquisition of its own shares by a third party, also applied to SARLs.
The clarification substantially increases the flexibility and certainty in the context of private equity transactions (including the associated acquisition financings) involving SARLs. However, any financial assistance granted by a SARL still needs to be carefully considered in light of the general requirement to act in the corporate interest of the SARL.
The Law of 8 December 2021 implementing the EU's Covered Bonds Directive (EU) 2019/2162 in force since 8 July 2022 (“Covered Bonds Law”) has expanded the list of authorised financial institutions that are allowed to issue covered bonds (lettres de gage) which was initially restricted to Luxembourg licensed mortgage banks (banques d’emission de lettres de gage) to all standard banks, subject to meeting certain financial thresholds and ratios. The Covered Bonds Law has also introduced a new label for European covered bonds and (high-quality) European covered bonds. The European covered bonds are issued in respect of the loans (i) secured by physical assets (or receivables in relation thereto) which are either publicly registered or otherwise subject to a certification satisfying the criteria set out by the Covered Bonds Law or (ii) issued to or guaranteed by public sector entities. In order to qualify as (high-quality) European covered bonds, covered bonds need to be secured by certain eligible assets meeting the requirements of and subject to conditions set out in article 129 of Capital Requirements Regulation (EU) No 575/2013.
The law will provide additional forms of safe investments for bondholders while also allowing Luxembourg banks to broaden the scope of their activities and boost their financial resources, which could also be used for a more active involvement in private equity transactions.
Updates to the Luxembourg financial collateral law
The Luxembourg law of 20 July 2022 amending the Financial Collateral Law has provided an official recognition of certain practices already used by legal practitioners which were not expressly provided for by the Financial Collateral Law, while also correcting certain inconsistencies and clerical errors from the previous version of the law and updating the list of optional enforcement methods.
The possibility of enforcing financial collateral arrangements following the occurrence of any event agreed between the parties (which could be not only a payment default, but also a breach of a contractual obligation, a representation or warranty or a financial covenant) has been expressly recognised by the revised Financial Collateral Law. This legal consecration removed the lingering uncertainty which surrounded the use of such trigger enforcements, despite their limited recognition in case law and acceptance by most legal practitioners.
The law also confirms the full applicability of the Financial Collateral Law to security interest over insurance contracts. This was already accepted in practice as regards the pecuniary rights of the policy holders and beneficiaries, but there remained some uncertainty in respect of other rights which were only related to the right to receive payment under insurance policies.
Among the changes regarding the (optional) enforcement methods, the provisions relating to sales via exchanges and public sales have been updated by including the reference to "trading platforms" on which the assets made subject to security are listed, which include the Luxembourg or foreign multilateral trading facilities (MTF) and organised trading facilities (OTF). The law has introduced detailed rules for enforcement by public sale, which can be conducted by either a public notary or a bailiff (and no longer only through the Luxembourg Stock Exchange) and expressly addresses the suspensive effect of any prior approvals from public authorities which may apply to certain types of entities, such as licensed entities.
Two alternative (and optional) valuation methods in case of appropriation of shares or units issued by a collective investment undertaking have been introduced: redemption of the pledged shares/units at the value provided for in the issuing documentation or appropriation at their most recent net asset value.
Additional changes to the revised Financial Collateral Law may be introduced by the bill n° 8055 filed on 27 July 2022 which, among other things, expressly recognises the possibility of having pledges over financial instruments using distributed ledger technology and will allow the use of distributed electronic registers in financial collateral arrangements.
Compounding of interest and market template of loan agreement
Luxembourg law currently only permits the compounding of interest in very limited circumstances. In the context of a loan agreement, interest can only be compounded if all of the following conditions are met (i) only due interest can be compounded; (ii) the interest must be due for a period of one year at least; and (iii) compounding of interest requires an agreement between the parties at the time of compounding of the interest or a judicial claim. These restrictions apply indistinctively to natural persons and legal entities.
As a result, it is often impracticable to compound interest in Luxembourg law governed loan agreements. This in turn results in certain types of financing products not being available or difficult to implement under Luxembourg law such as PIK financings and is also generally an impediment to attracting certain foreign lenders to making available financings under Luxembourg law. It would therefore be desirable if the compounding of interest rules could be loosened for parties which are not consumers (within the meaning of article L.010-1.1) of the Luxembourg consumer code). The necessity of addressing this longstanding shortcoming is currently the focus of several professional associations and this could lead to a long awaited amendment of Luxembourg law in the near future. As an additional effort to increase the attractivity of Luxembourg law for international financings, several law firms are collaborating on a project aiming to produce an unofficial LMA-style template of Luxembourg law facility agreement, allowing the streamlining of transactions.
Bankruptcy law reform
Bankruptcy (faillite), aimed at liquidating the assets of insolvent undertakings, is the only Luxembourg insolvency proceeding actually used in practice, with obsolete proceedings relating to the continuity of business being very rarely used due to the fact that they depend exclusively on the consent of creditors and have only a limited stay effect on their claims. Restructurings aimed at the survival of companies generally are negotiated out of court, but in the absence of a statutory framework they are viable only in case there is a limited number of coordinated creditors. Initially introduced in 2013, the current bill 6539A aims to modernise the Luxembourg insolvency law, which while remarkable for its stability, remains largely based on outdated provisions of Belgian law.
The complexity of the reform has resulted in the bill being stalled for years but has recently gained momentum due to the need to implement the Directive (EU) 2019/1023 of the European Parliament and of the Council on restructuring and insolvency of 20 June 2019 and could finally materialise in a change of law in the coming year.
The draft bill aims to achieve a comprehensive reform and includes several preventive, repressive, restorative and social provisions which aim to reduce, or at least stabilise, the recent increase of bankruptcies and significantly improve the restructuring options for debtors. The main innovation is the introduction of judicial reorganisation, which can be initiated only upon the request of the debtor in the event the continuity of its activity is threatened by financial difficulties. The filing of the application will result in an automatic stay for all unsecured creditors until the end of the proceedings. The outcomes of the process can be (i) a court-sanctioned moratorium agreement between one or several creditors and the debtor (also called cramdown); (ii) a reorganisation plan concerning whole or part of the business, which, after having been accepted by a majority of creditors, will be binding on all creditors or (iii) the transfer of all or part of the assets decided by court, which does not require the consent of the creditors, although their interests need to be considered by the court. Another innovation would be the introduction of the voluntary agreement with creditors, under which the agreement between the debtor and two or more of its creditors, which can be mediated by a conciliator, applying in respect of all or some of its assets or activities. The key change from the current provisions is that such voluntary agreement will not be affected by the subsequent opening of bankruptcy and thus the risk of clawback during the hardening period.
When implemented, the bill will offer the Luxembourg based private equity actors additional tools for restructuring distressed businesses, which, due to their statutory recognition, would provide a higher degree of certainty compared to purely voluntary agreements between creditors, which are more difficulty enforceable and vulnerable to the consequences of a subsequent bankruptcy.
As a conclusion, all of the above intended or adopted changes will undoubtedly contribute to increasing the attractiveness of Luxembourg law for international financing transactions. While they may not be a standalone solution for creating a legal framework covering all the needs of international financings, the abovementioned Luxembourg legal tools together with other legal instruments, already part of the Luxembourg legal toolbox, certainly provide national and international players with quite flexible means to structure international financings. The success of Luxembourg law will however depend on the willingness of public decision makers to constantly keep adapting to the international legal landscape by implementing competitive and innovative tools. It is also the responsibility of legal practitioners, Luxembourg courts and Luxembourg financial institutions to continue challenging themselves to offer the best possible market and legal conditions for financial institutions and their clients and encourage the use of Luxembourg law in international transactions.