Luxembourg Financial Collaterals 3rd Ed., June 2011

Luxembourg Financial Collaterals
Structured Finance & Tax
Third Edition - June 2011

Established in 1923

This third edition integrates the legislative updates introduced by the law of 20 May 2011.

Luxembourg Financial Collaterals 2|P a g e

CONTENTS

INTRODUCTION 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


INTRODUCTION
THE CHALLENGE: SECURING
AN UNSECURED ENVIRONMENT


THE LESSONS OF THE FINANCIAL CRISIS

In 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 financial
downturn, 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 give
investors their expected return.

In contrast, the guarantees’ aspects came like second in row at the time, as a required yet relatively
accessory part of an acquisition’s package. Lenders required an acceptable security package as their
sole coverage against the default. However, in those happy days of positive thinking, a major default
situation was regarded as remote. Leveraged debt’s proportion was higher and higher, each
leveraged 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 dramatic
financial and economic worldwide downturn was immediate: a number of companies purchased
pursuant to recent highly leveraged buy-outs were no longer in position to fulfil their repayment
obligations and entered the default danger zone.

There comes the time of debt restructuring … there comes the time of testing the resistance of the
security package …

Indeed, there are circumstances in which the debt restructuring does not consist in simply refinancing
the existing acquisition structure. It may be that the initial investors are not willing or are not in position
to take part in the refinancing. The acquisition structure must be then partly or fully taken over by
others who are either one/several existing lender(s) or new investors. The security package must be
then dismantled and wholly reconfigured.

For the first time in 2009, Luxembourg financial collaterals were subject to enforcement. That
enforcement exercise was a première, quickly followed by further similar cases. Those enforcement
exercises 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 lawyers
had to find adequate responses and Luxembourg courts had to provide judicial interpretations on
critical legal issues.

The present developments specifically aim at exposing, from a Luxembourg perspective, the lessons
which may be drawn up from such enforcement tests. Hopefully, the interest of the following
developments shall largely exceed the crisis period. In the future, as it has been in the past, leverage
will still be at the core of the LBO model. However, taking good note of the crisis’ lessons, lenders will
be more eager than ever to be comforted with a strong reliable security package. That will be the price
to pay for the lenders’ commitment and affordable credit conditions.


 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 package


WHY A TWO-TIER LUXEMBOURG SECURITY PACKAGE?

For several years, the Luxembourg two-tier structure has been regarded as one of the most adequate
security package structures.

In a nutshell, and as shown in the chart below, LuxCo 1, in its capacity as guarantor of the facilities
lent by the Lenders (Senior and Junior) to Bidco SPV, grants the Security Trustee financial collaterals
over 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 efficiency


THE TAX CHALLENGE

While the two-tier structure provides an efficient security package to the
lenders, 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.


An acquisition structure organised in Luxembourg does not have, in principle, specific taxes levied on
it upon its implementation: on 1 January 2009, Luxembourg abolished the 0.5% capital duty which
has been replaced by a EUR 75.- fixed registration fee and Luxembourg does not levy any stamp duty
upon transfer of the shares of a Luxembourg company

Depending on the nature of the investments (real estate, private equity, multiple targets, etc.) and the
status of the investors (qualified investors or not), the Luxembourg double-tier structure can be set up
through Luxembourg by the use of two Luxembourg unregulated companies having the object of a
Soparfi. The Soparfi (Société de participation financière) is a standard commercial company
organised under one of the corporate forms (public limited liability company (SA), private limited
liability company (Sàrl) or, limited partnership (SCA)) set forth by the law of 10 August 1915 on
commercial companies, as amended. The Soparfi is therefore treated as a standard company, either
from a corporate point of view (there are no restrictions relating to its corporate object, which can be
broadly drafted) or from a tax perspective (Soparfis are fully taxable companies). As a result, Soparfis
are not excluded from the benefit of the tax treaties concluded by Luxembourg or from the benefit of
the EU Parent-Subsidiary Directive regime.

As indicated on the above structure, the acquisition will in general be financed through different
channels:

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 securities


TAX TREATMENT OF THE FUNDS FLOW THROUGH THE LUXEMBOURG TWO-
TIER STRUCTURE

THE TAX TREATMENT OF THE PAYMENT OF INTEREST

As indicated in the above standard structure, interest payments will be made by the two Luxembourg
companies on inter-company loans. The payment of interest by a Luxembourg company is generally
not subject to withholding tax (“WHT”), except in certain limited cases, which can be summarised as
follows:

 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 unless
they are in direct relation to exempt income. Where Bidco SPV is the borrower, the standard
Luxembourg double-tier structure would generally allow Bidco SPV to have the interest paid to the
lenders as deductible expenses. On-lent by Luxco 1 made on an arm’s length basis, i.e. Luxco 1
realises an arm’s length margin on this financing activity which would be subject to corporate income
tax (“CIT”) and municipal business tax (“MBT”), is disregarded for thin capitalisation rules purposes.

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 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.


THE TAX TREATMENT OF THE CAPITAL GAIN AND DIVIDEND INCOME
DERIVED FROM THE BIDCO SPV

The capital gain realised by LuxCo 2 upon transfer of its participation in Bidco SPV is in principle
subject to CIT and MBT levied at the current combined rate of 28.59% (this is the current rate for
companies established in the city of Luxembourg – this rate is expected to rise up to 28.80% as from
1 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 be
subject to certain restrictions where, for example, financing expenses relating to the acquisition of the
participation have been previously deducted (for example if the participation is financed by an interest
bearing 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 million
acquisition price). This means in practice that holding period is deemed to be continued until the last
tranche 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 gains
realised by LuxCo 2 upon successive transfers of up to 90% of Bidco SPV shares before 1 August
2011 will be tax exempt in Luxembourg.

Finally, the conditions allowing LuxCo 1 to benefit from the participation exemption upon realisation of
a dividend income by LuxCo 2 are similar to the conditions mentioned above for the capital gain
except that the acquisition price of the participation alternative criteria, is EUR 1.2 million instead of
EUR 6 million.

Bidco SPV should also ideally (but this is not mandatory for an efficient tax structure) be located in a
country offering a dividend WHT exemption on dividend payments made to LuxCo 2. A company
located in EU countries should offer such exemption, provided, inter alia, that the Luxembourg
structure 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 from
the participation, e.g. interest expenses, and potential write-downs in the value of the participation), to the extent that they
have reduced the taxable base of that year or previous years.


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)


THE TAX TREATMENT OF THE CAPITAL GAIN AND DIVIDEND INCOME
DERIVED FROM LUXCO 2

The funds flow between the two LuxCos does, in principle, not trigger any tax leakage. Subject to
certain conditions, the distribution of dividends can be made free of withholding tax at the level of
LuxCo 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 from
the mirroring debt existing at the level of LuxCo 1 (except for an arm’s length margin on the financing
activity).

THE REPATRIATION OF PROCEEDS TO THE INVESTORS

Luxembourg displays several well trodden paths allowing efficient tax planning structures used to
upstream the funds back to the investors. Several instruments can be used, depending on the needs
of the investors.

 Hybrid instruments: PECs/CPECs

PECs (Preferred Equity Certificates) and CPECs (Convertible Preferred Equity Certificates) are hybrid
(debt/equity) instruments which can have several other denominations and which have been
developed by Luxembourg practice over the last few years. They are usually used to finance an
investment realised by a Luxembourg company. These instruments are not regulated by law or by
administrative guidelines. These instruments qualify as hybrid instruments due to their features, which
are a subtle combination of equity and debt. The common equity features of the PECs and the CPECs
are:

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 usually
considered as creditors. As a result, they do not have voting rights and do not bear any losses of the
issuing company. In the jurisdiction of the holder of the PECs/CPECs, holders are normally
considered as having equity.


The PECs/CPECs are flexible, made-to-measure, instruments. They may be convertible into shares
or, upon exit (the exit events being set out in the PECs/CPECs terms and conditions negotiated
between the issuer and the subscriber), can be redeemed at market value without triggering any
withholding taxes (which is very efficient for exit scenarios). They can bear a yield or be yield-free.

 Income-Sharing Debt

Income sharing debt, such as profit participating loans (“PPL”), can also be used as an exit strategy
instrument 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 Luxembourg
company. Provided the instrument is properly drafted, the payment of that variable interest is in
principle not subject to Luxembourg withholding tax (although a residual withholding tax may have to
be levied depending on the financing structure in Luxembourg) and is fully deductible. The use of
income sharing debt may be particularly useful when the income derived from a subsidiary and
realised by a Luxembourg company is not eligible for the participation exemption (this should not be
the case in the analyzed double-tier structure regarding dividends paid by Luxco 2 to Luxco 1) and/or
when the dividends paid by a Luxembourg company to its shareholders may be subject to
Luxembourg withholding tax.

Double-tier structure also allows a higher indebtedness since LuxCo 1 would on-lend the
funds to LuxCo 2. Provided that certain conditions are met (in particular leaving an arm’s
length 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 equity
ratio (being 85:15).

 Liquidation

Liquidation is a well-known Luxembourg exit strategy. A Luxembourg resident company which is put
into 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 participation
exemption 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 upon
liquidation of the Luxembourg company in which he holds a participation. Realising a capital gain
upon the sale of shares in a Luxembourg company is taxable in Luxembourg only if such non-resident
shareholder has held a participation of more than 10% in the company’s share capital which is
alienated (i.e. liquidated) within six months of its acquisition or if such shareholder has been a resident
taxpayer for 15 years and surrendered its tax residence less than five years before the alienation. As
a result, the taxation of a liquidation surplus received by a non-resident shareholder is applicable only
in rare cases.


 Classes of Shares

Luxco 1 can also be set up with a share capital represented by several classes of shares (usually up
to ten classes) allowing for repatriation of profits via withholding tax exempt redemption of such
classes of shares (i.e. partial liquidation of one class of shares). This tax treatment is however subject
to 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 shareholders


THE TAX IMPLICATIONS OF SECURITIES GRANTED AT THE LEVEL OF THE
LUXEMBOURG COMPANIES

THE TAX TREATMENT OF THE SECURITIES PROVIDED BY LUXEMBOURG
COMPANIES

When a Luxembourg company provides guarantees, the questions of transfer pricing and deemed
remuneration should be considered.
An upstream guarantee: the
In principle, Luxembourg practice does consider when a Luxembourg company guarantees
Luxembourg company provides with a downstream guarantee, the obligations of its parent
in 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: the
an upstream guarantee or a cross-stream guarantee. In such Luxembourg company guarantees
a case indeed, the Luxembourg tax authorities may consider the obligations of a sister
that the Luxembourg company should be allocated an company).
appropriate guarantee fee in remuneration of such services.

UPON ENFORCEMENT OF THE SECURITIES: SOME TAX ASPECTS

Depending on the alternative chosen by the creditors in proceeding to the enforcement of the
securities, specific tax aspects may rise. A typical implementation method, is the pledgee selling or
causing the pledged assets (in our example the Luxco 2 shares, CPECs, and receivables) to be sold
in a private transaction at normal commercial terms (conditions commerciales normales) to an SPV
set up for the purpose of the enforcement.

 Stamp Duty upon Transfer of the Assets

As a principle, no transfer tax or stamp duty is due upon transfer or enforcement of shares, CPECs or
receivables (unless the transfer deed is registered on a voluntary basis).

 Capital Gains Realised by the Pledge/Security Trustee upon Transfer of the Assets

It is likely that Luxco 1 will not realize any capital gain upon enforcement of the securities by the
pledge or the security trustee. However, once the assets transferred to the SPV, such SPV may in
turn transfer the assets to a third party. In this case, care should be taken regarding the taxation of
possible capital gains realised upon transfer. We recall that capital gains realised by a fully taxable
company 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 capital


gains, realised by a Luxembourg company on the disposal of shareholdings, are tax exempt provided
that 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 particular
the shares of Luxco 2) and if the pledgee is a non-Luxembourg resident, such non-resident
shareholder 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 Interest

Interest 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 interest
expenses. Since it is unlikely that interest expenses would be available at the level of the SPV, the tax
treatment of the waiver of the existing inter-company receivable should be considered.

 Waiver of Debt SPV toward Luxco 2

Upon enforcement of the pledge, the SPV may become a creditor towards Luxco 2. It is likely that
Luxco 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. In
principle, such a waiver of debt should result in a taxable profit in the hands of Luxco 2, which can be
offset by current year losses or, if available, tax losses carried-forwards. In addition, the gain resulting
from such a waiver may be exempt at the level of Luxco 2 under certain conditions, one of which is
that such waiver is granted with the intention of re-establishing the debtor’s financial situation (en vue
de l’assainissement de l’entreprise).


If the pledgee is a Luxco 2’s shareholder (which is likely after enforcement of a share pledge), a
waiver of debt may be qualified as a hidden contribution in favour of Luxco 2 in application of the
economic analysis principle. In such a case, there should be no profit recognition and losses carried
forward 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 Duty

In principle, loan agreements (excluding, among others, bond issuances and other negotiable
instruments) are subject to an ad valorem duty of 0.24% where they are registered. The taxable basis
of this 0.24% should be the principal amount of the principal mentioned in the agreement subject to
registration. Although the registration of loan agreements is not mandatory at the time the loan
agreement is entered into, Luxembourg courts may order the registration of all documents that are
produced in Luxembourg proceedings. Attention should therefore be paid when drafting the pledge
agreement in order to mitigate such risk of taxation.


THE SECURITY
PACKAGE CHALLENGE
From the outset, Luxembourg regarded the EU Directive 2002/47 EC on
financial collateral agreements (the “Directive on Financial Collateral
Arrangements”) as a unique opportunity to implement into its national
legislation a legal instrument fully protective of the interests of the lenders.
The law of 5 August 2005 on financial collaterals (the “Law on Financial
Collateral Arrangements”) has embodied such mechanisms in a
comprehensive manner placing Luxembourg financial collaterals in a leading
position. The latest amendments to the Law on Financial Collateral
Arrangements, which were introduced by the law of 20 May 2011, have
confirmed the friendly-creditor features of the Luxembourg legal framework.


HIGHLIGHTS OF THE LAW ON FINANCIAL COLLATERAL ARRANGEMENTS

BACKGROUND – DIRECTIVE ON FINANCIAL COLLATERAL ARRANGEMENTS

As part of the EU single market scheme, the need was felt to favor a harmonized regime for financial
collateral arrangements. The implementation of that harmonized Community regime was regarded as
soundly contributing to the integration and cost-efficiency of the financial market as well as to the
stability of the financial system, thereby supporting the freedom to provide services and free
movement of capital in the single market in financial services.

The Directive on Financial Collateral Arrangements targeted one main objective: providing the
maximum 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 –
INTRODUCTION

Luxembourg law had already anticipated some of the innovations of the Directive on Financial
Collateral Arrangements pursuant to, in particular, the law of 1 August 2001 on the transfer of
ownership as guarantee.

The Directive on Financial Collateral Arrangements was therefore regarded by the Luxembourg
legislator as a unique opportunity to implement into national legislation a legal instrument fully
protective of the interests of lenders. Legal certainty is at the core of the Law on Financial Collateral
Arrangements.

The Law on Financial Collateral Arrangements has coordinated in one set of provisions a number of
disparate legal provisions, forming an easily readable legal unity. Part II of the Law on Financial
Collateral Arrangements sets forth a comprehensive legal regime for pledge agreements, which
derogates from the general pledge legal regime set out in the Luxembourg Civil Code and the
Luxembourg Commercial Code.

The Luxembourg legislator is eager to take any opportunity to improve the Law on Financial Collateral
Arrangements. Such an opportunity arose in the context of the transposition into Luxembourg law of


the European directive 2009/44/EC of 6 May 2009, which has amended in particular the Directive on
Financial Collateral Arrangements. Within this transposition exercise which was enacted by the law of
20 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 Regime

The general regime of a pledge in the context of the Law on Financial Collateral Arrangements follows
the general outlines of the legal regime of the pledge, set out in Articles 2071 seq. of the Luxembourg
Civil Code.

As a private agreement pursuant to which a debtor (the pledgor) allocates a particular asset or a
category of assets to his creditor as a guaranty, the pledge is a legal instrument well-known to
Luxembourg practitioners, the legal regime of which having been thoroughly interpreted for decades
by the Luxembourg courts.

 Limited Cost

Considering the considerable financial implications that the financial collateral arrangements
represent for the investors and the lenders, implementation of Luxembourg financial collaterals under
the 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 vehicle
used is the Sàrl, with a minimum subscribed share capital of EUR 12,500. Also, some of the funds
used to pay in the share capital of LuxCo 1 may be further used, at least in part, by LuxCo 1, for the
purpose of paying in the share capital of LuxCo 2 at incorporation.

In terms of contractual legal paperwork, the financial collateral arrangements will be mainly
represented by one or several standard pledge agreements (share pledge agreement, hybrid
instruments’ pledge agreement, account pledge agreement, receivables’ pledge agreement), which
will be governed by the Law on Financial Collateral Arrangements.

Pursuant to Article 26 of the Law on Financial Collateral Arrangements, Luxembourg financial
collaterals are not subject to any taxes or registration duties. In case of voluntary registration by one
or either parties, they are subject to a EUR 12 flat registration fee. It is only in very limited cases that a
0.24% ad valorem duty may be due (cf. section “Upon enforcement of the securities: some tax
aspects”).


 Unrestricted Personal Scope

There are no restrictions under the Law on Financial Collateral Arrangements in respect of the
pledgor. The pledgor may be a private individual or a private or a public corporate body. It may be the
main 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 Powers

In the context of syndicated financing, the Law on Financial Collateral Arrangements has addressed a
specific issue relating to the involvement of a security trustee holding the pledged assets on trust, for
the 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 an
accessory to the underlying secured debt. As a result, the pledgee must necessarily be the creditor of
the underlying debt. The standard concept of “créancier-gagiste” mirrors that intrinsic link between the
security (pledge) and the underlying secured debt. The security trustee is not necessarily the creditor
of the secured debt. In order to respond to the issue originating in a conflict between common law
mechanisms (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 collateral
arrangement 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 trustee
benefits from the same rights as the rights conferred to a “créancier-gagiste”, without any prejudice to
its specific obligations as trustee vis-à-vis the lenders.

 Scope of the Underlying Secured Debt

Any and all current, future, term or conditional obligations may be secured by a pledge agreement in
the meaning of the Law on Financial Collateral Arrangements, whether these obligations are owed by
the pledgor or by a third party.

 Pledgeable Assets

Any types of receivables and financial instruments may be subject to a pledge agreement within the
meaning of the Law on Financial Collateral Arrangements. The Law on Financial Collateral
Arrangements expressly states that the idea of pledgeable assets must be interpreted as widely as
possible including:


 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 the
above 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 governing
law thereof.

In practice, the effect of the comprehensive scope of pledgeable assets under the Law on Financial
Collaterals is that all assets held by LuxCo 1 are in principle subject to pledge, whether the shares
subscribed 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 broad
interpretation of pledge is a noteable feature of the Law on Financial Collaterals for investors and
lenders.

 Ownership/Dispossession of the Pledged Assets

One specific aspect of the pledge under Luxembourg law is dispossession of the pledged assets from
the hands of the pledgor, to the hands of the pledgee or an agreed third party. As a result, the
pledgee does not incur the risk of having the pledged assets escaping its control as long as the
pledge remains in place.

The ownership of the pledged assets remains in the hands of the pledgor. The difficulty may be for the
pledgee to ascertain the pledgor’s ownership, at the risk of having the pledge put at risk in the event
the ownership is uncertain or claimed by a third party. The Law on Financial Collateral Arrangements
addresses 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.


 Tailor-Made and Light Formalities of Implementation and Dispossession

In the context of immaterial assets such as financial instruments, receivables, assets held on bank
accounts, the Law on Financial Collateral Arrangements sets up an informal process of
implementation and dispossession of pledged assets, either by way of registration (registered
financial 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 Pledges

Complex financing transactions generally involve the principle of subordination of certain debts. This
is 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 pledge
over 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-ranking
pledges. 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 Assets

In respect of the allocation of the voting rights and rights to dividends over pledged shares or other
securities granting such rights, the Law on Financial Collateral Arrangements adopts a liberal
approach by allowing the parties to allocate voting rights and dividends to each other according to the
best of their respective interests. Where the pledgee has the voting rights, it allows him to convene
shareholders’ meetings, take shareholders’ resolutions or to dismiss the management in place and
appoint new managers. This wide scope of action granted to the pledgee was expressly confirmed by
the 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.


 The provider of a financial collateral can waive in anticipation any rights of subrogation
or recourse it may have

This issue had proved critical in the context of several debt restructuring scenarios which took place in
Luxembourg. By way of legal subrogation, the pledgor, which was deprived from its shares pursuant
to the enforcement of the pledge over those shares, was subrogated in the rights of the pledgee and
then had a claim – equal to the value of the shares subject to enforcement - against any other debtors
or guarantors of the secured claims. As a result, the risk was that the pledgee took control – in case of
appropriation of the pledged shares – of an entity which became itself the debtor of the pledgor. This
subrogation effect was clearly detrimental to the interests of the pledgee and substantially diminished
the value of the pledged assets.

In practice, this risk was covered by specific provisions in the pledge documentation: the pledgor
expressly waived any rights of subrogation or recourse, either legally or contractually-based, it may
have. However, it was questionable whether this anticipated waiver fully met the Luxembourg civil law
principles. It was therefore desirable that the Law on Financial Collateral Arrangements clarify this
issue. The Luxembourg legislator took the opportunity of the law of 20 May 2011 to meet this
expectation.

 Full Immunization against the Pre-Insolvency or Insolvency Risk of the Pledgor

 A top priority concern for the Luxembourg legislator

The protection of a pledgee’s rights in the event of a pledgor’s
insolvency is obviously a major concern. Pre-insolvency and Taking the guidelines of the
insolvency measures generally generate suspension or even Directive on Financial Collateral
nullification effects vis-à-vis any types of guarantees which may Arrangements to the word, the
be held against an insolvent debtor. Law on Financial Collateral
arrangements provides a
That major topic was addressed by the Directive on Financial
comprehensive set of
Collateral Arrangements as a primary concern at a coordinated
EU level. However, the Member State’s legislations have mechanisms aiming at fully
adopted rather dissymmetrical approaches with regard to the protecting the pledgee’s rights
fair balance level to be set up between those two conflicting against the insolvency risk.
legal matters. In particular, some jurisdictions are less prone Luxembourg courts have given
than 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 or
workers.

While transposing the Directive on Financial Collateral Arrangements, the Luxembourg legislator was
miles away from such a multi-interests’ approach: the protection of the lender/pledgee was the
primary concern.


 Express legal provisions

Claw-back period’s limitations are a cause for major concern for guarantee holders. Article 20 (1) of
the Law on Financial Collateral Arrangements expressly excludes any claw-back risk by stating that
the financial collateral arrangements, as well as the facts triggering the enforcement thereof, are valid
and enforceable vis-à-vis third parties, commissars, curators, receivers, liquidators or other similar
organs notwithstanding any Luxembourg or foreign pre-insolvency or insolvency measures, as well as
vis-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 concluded
on the opening date of the pre-insolvency or insolvency measures, provided that, where the pledge
was agreed after the actual opening of such measures, the pledgee was unaware that such measures
were 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. It
demonstrates to what extent the Luxembourg legislator intended to immunise financial collaterals.

Fully aware that Luxembourg financial collaterals are most generally concluded in the context of
international transactions, the Luxembourg legislator was eager to extend the pledgee’s protection
against the potential risks incurred by foreign pre-insolvency or insolvency measures which may apply
vis-à-vis the pledgor and/or the pledged third party. Article 20 (1) of the Law on Financial Collateral
Arrangements fully embodies such extension, which may be regarded as an extra-territorial loi de
police, evidencing the willingness of the Luxembourg legislator to cover the widest scope of
immunization of the Luxembourg pledges against the pre-insolvency and insolvency risks.

 The strong case-law support

Most 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 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 risk


THE TWO-TIER LUXEMBOURG SECURITY PACKAGE

THE FRAMEWORK: CREATING A FULL LUXEMBOURG SECURITY PACKAGE

 The Pledgor and the Pledged Third Party are Luxembourg Entities

Setting 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 the
light 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 to
the pledgee that the full effect against pre-insolvency or insolvency risk of the pledgor, as set out by
the Law on Financial Collateral Arrangements, will be recognized and given full force and effect. On
the other hand, pre-insolvency or insolvency measures ordered by non-Luxembourg courts potentially
have the risk that the protection of the pledgee’s rights under the Law on Financial Collateral
Arrangements may be set aside by foreign courts. It may not be conclusively anticipated that foreign
courts, taking their capacity and power from the EU Regulation 1346/2000 relating to international
insolvency proceedings, will necessarily accept the prevalence of the Law on Financial Collaterals
over the strong powers conferred to them by the EU Regulation 1346/2000.

 All Pledged Assets are Located in Luxembourg

It 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 being
essentially rights in rem, the law of the situs of the pledged assets governs, according to private
international 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 jurisdiction
which is competent to open the main insolvency proceedings and to have such proceedings governed
by the law of that jurisdiction applies, as a matter of principle, to all of the assets of the insolvent
company, wherever the assets may be located (principle of universality of the insolvency


proceedings). However, the EU Regulation 1346/2000 reserves, at certain conditions, the jurisdiction
of the courts of other members States (secondary insolvency proceedings) in respect of assets which
are located in such other members States. The attraction of the law of the situs justifies such
derogation to the universal character of the main insolvency proceedings. It may not be excluded that
the secondary insolvency proceedings opened in such other member States may have as effect to
limit the full recognition and efficiency of Luxembourg financial collaterals.

The Luxembourg two-tier structure ensures that all assets pledged by LuxCo 1 are effectively
regarded 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 ENFORCEMENT
PROCESS

It is at the time of enforcement that guarantees do evidence their value. At that critical
moment, it is of a paramount importance that the enforcement proves straightforward and
efficient.

 The Breach of any Contractual Obligation Allows to Enforce the Pledge

The Law on Financial Collaterals gives full effect to contractual freedom. The parties are free to
determine any event of default, not necessarily a payment default, triggering the enforcement of the
pledge. By providing that no acceleration – or at least not full acceleration – of the underlying debt is
required to enforce the pledge, the Law on Financial Collaterals goes further than the Directive on
Financial Collateral Arrangements.

The Law on Financial Collaterals departs from the classical concept of the security as an accessory
of the secured debt’s repayment.


 The Full Scope of Enforcement Measures

The Law on Financial Collaterals allows the pledgee to enforce a pledge according to the following
enforcement 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 Luxembourg
legislator to implement all enforcement measures which were encompassed within the Directive on
Financial Collateral Arrangements. In particular, implementation into national legislation of the
appropriation measures was merely optional for the EU Member States.

 A Non-Formalistic Enforcement Process

Time is of the essence in the enforcement process. Any delays, additional formalities, interventions
of public or judicial authorities are undoubtedly detrimental to the pledgee’s interests. While
transposing the Directive on Financial Collateral Arrangements into Luxembourg law, the
Luxembourg legislator was therefore determined to eliminate as much as possible any hurdles in
that respect.

1
The right granted to a third party to appropriate the pledged assets, as well as the right to appropriate before completion of
the valuation process, were expressly confirmed by the law of 20 May 2011.


 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 risk

As a reminder, one main concern of the Luxembourg legislator while enacting the Law on Financial
Collateral Arrangements was to protect the pledgee’s rights against the pre-insolvency and insolvency
risks at the level of the pledgor and pledged third party.


In that respect, Article 20 (1) of the Law on Financial Collateral Arrangements expressly states that
financial collateral arrangements, as well as the facts triggering the enforcement thereof, are valid and
enforceable vis-à-vis third parties, commissars, curators, receivers, liquidators or other similar organs
notwithstanding any Luxembourg or foreign pre-insolvency or insolvency measures. That core
principle is repeatedly stated in several other provisions of the Law on Financial Collateral
Arrangements and was given full effect by the Luxembourg courts which qualified this principle as a
loi 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 pledgor


LUXEMBOURG FINANCIAL COLLATERAL PRACTICE: LESSONS OF THE
FINANCIAL CRISIS

DEBT RESTRUCTURING: A RESISTANCE TEST FOR THE LUXEMBOURG
FINANCIAL COLLATERALS

Not unsurprisingly, since the outbreak of the financial crisis in early 2008, an increasing number of
debt restructurings have necessitated the enforcement of Luxembourg financial collaterals. These
enforcement measures took place in the context of either consensual or non-consensual debt
restructurings. In the latter cases, the dissenting interests between the different lenders to the
syndication generated tensions which required from the legal counsels involved a particular expertise
in 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 worried
public authorities (states, regions), media focus –justified that such debt restructurings, including the
Luxembourg financial collaterals’ enforcement process, be conducted cautiously.

The enforcement exercises were a first in Luxembourg. As a result, the Luxembourg practitioners did
not benefit from the experience of previous similar transactions and were exposed to a number of new
legal issues. It can be therefore regarded of some interest to expose some of those issues, together
with 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 COLLATERALS
EXERCISES PROVED THEIR EFFICIENCY

Before examining the specific legal issues raised by enforcement exercises, it must be
stressed that the Luxembourg financial collaterals successfully passed the enforcement test.

One of the most notable features of the Luxembourg financial collaterals, namely their non-formalistic
character, 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 commercial
conditions. In addition to the fact that such enforcement measure is privately conducted and therefore
does not require the intervention of any public authorities (courts, stock exchange), the security
trustee is not eager to favour the appropriation of the pledged assets, even for a second.


LEGAL ISSUES RAISED BY THE PRIVATE SALE MADE UNDER NORMAL
COMMERCIAL CONDITIONS

 The Concept of “Normal Commercial Conditions”

 The issue: the law is silent

The condition and concept of “normal commercial conditions”, as referred to by the Law on Financial
Collateral 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 question
the validity of the sale.

 The practice interpretation

Due to the initial absence of judicial precedents at the time, practitioners rapidly came to a first
consensus: “normal commercial conditions” may not be necessarily interpreted as relating to a normal
market situation. The specific downgraded economic and financial situation at the level of the target
group 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 be
considered. Organising a private auction may be considered and that way may be regarded as closely
responding to the requirement of creating the conditions of a real market. However, the practical
downside of an auction sale may not be overlooked, either in terms of cost, confidentiality, real
efficiency concern in the context of a most deteriorated situation of the target group, as well as in
terms of time required. Indeed, in such debt restructuring situations, time is of the essence of the
success and having a private auction settled, with burdensome notice requirements, may jeopardise
the fair achievement of the whole restructuring process.

A more efficient and reasonable modality of determining the sale price according to the normal
commercial conditions’ criterium was found in asking an independent reputable audit firm to determine
thevaluation of the pledged assets. The audit firm will conduct the valuation according to its highest
professional standards pursuant to an in-depth economic and financial analysis.

 The case-law confirmation

The practice’s analysis was massively comforted by a judgment of 20 May 2010 rendered by the
District 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 conditions
applicable to the assets at stake”. The interpretation by the court clearly favored an in concreto
interpretation of the concept of “normal commercial conditions”. In addition, the court emphasized that
the Law on Financial Collateral Arrangements does not even require from the pledgee to conduct an
independent valuation of the pledged assets before being entitled to enforce the pledge.


 The Concept of “Sale”

Under which form the purchaser must pay the price can raise difficulties. Must the price be under the
form of a monetary amount only or is the purchaser entitled to pay in kind? That question arose in the
context of enforcement exercises in which it was contemplated that the seller may receive Payment In
Kind Notes in payment for the sale of the pledged assets. Does such a mode of payment still relate to
a 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 Financial
Collaterals?

On that particular issue, no firm consensus exists. As a result, any conservative approach should be
reluctant in admitting a payment for the purchased assets other than in the form of a monetary
amount, either by immediate or postponed payment.

THE LITIGATION RISK

In the context of enforcement measures by which investors are utterly deprived of the control
of the target group, further litigation risk must be considered seriously. It must also be taken
as seriously in the context of non- consensual restructuring exercises whereby some junior
lenders may be excluded from the restructuring lenders’ syndication and their return on
investment expectations may be massively, impacted. In any case, the litigation risk should
not be overlooked. However, Luxembourg courts clearly favor legal safety and the full
efficiency of the financial collateral arrangements.

 The Two-Folded Litigation Risk: Main Proceedings / Summary Proceedings

 Main proceedings

Limited Scope of Luxembourg Main Proceedings

As a matter of principle, main proceedings initiated in relation to the enforcement of Luxembourg
financial collaterals should have a scope limited as to the verification by the Luxembourg courts that
the conditions of enforcement were fully complied with. In the context of enforcement measures under
the 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 the
financing documentation (Facility Agreement, Intercreditor Agreement), given that those documents
are generally governed by a law other than Luxembourg law and that jurisdiction clauses give
exclusive jurisdiction to the courts of the governing law state. However, it must be checked in each
case whether such exclusive jurisdiction applies to all parties or only to some of them (borrower). In
the latter case Luxembourg courts may also have jurisdiction in respect of the financing documents.


Effects of Luxembourg Main Proceedings

If the enforcement of the financial collaterals was not made in conformity with the contractual facts
and circumstances duly triggering the enforcement of the financial collaterals, or that the sales were
not 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 or
alternatively, may only grant damages. A risk of having the decision reduced would clearly be a cause
of major concern for the parties involved in the enforcement process given, that it would jeopardise
the whole debt restructuring process. Although the Law on Financial Collaterals is not clear in respect
of that major issue, it was generally interpreted as permitting only the granting of damages. This
analysis 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 the
sale yet is under the form of damages”.

 Summary proceedings: Strict Limitations Set Forth by Luxembourg Courts

According to Whereas 17 of the Directive on Financial Collateral Arrangements, judicial control of the
enforcement measures should be restricted to post-enforcement. That judicial restraint is in line with
the general trend of the directive aiming to eliminate, to the possible extent, any obstacles which
would impair the full efficiency of the financial collaterals. In that respect, EU Member states’ courts
should refrain from admitting their jurisdiction in the context of ex-ante summary proceedings, by
which the claimants would attempt to slow down the enforcement process.

However, once enforcement proceedings have begun, it may not be excluded that, in the further
perspective of main proceedings, claimants may be tempted to take advantage of swift summary
proceedings. The purpose of such summary proceedings is to have the enforcement effects frozen or
the assets put in escrow until the claim is ruled as to the merits in the course of further main
proceedings.

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 out
that judicial freezing provisional measures further to enforcement are not permitted. This paramount
decision is a strong support for legal safety which is at the core of the Law on Financial Collateral
Arrangements.

 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.


THE PRE-INSOLVENCY AND INSOLVENCY RISK

As detailed above, the Luxembourg two-tier structure set up in accordance with the Law on
Financial Collaterals fully provides immunization against the pre-insolvency and insolvency
risk. However, in order to escape the insolvency immunization, some may try to transfer the
centre of main interests (COMI) of LuxCo 1 and LuxCo 2 to a jurisdiction which does not
recognise that immunization, with the detrimental effect of jeopardising the efficiency of the
Luxembourg financial collaterals. For the purpose of neutralising such escape attempts,
counter-measures must then be considered.

 Risk of Transfer of the COMI

The COMI is determined pursuant to factual elements The concept of COMI is instrumental
such as the place where corporate decisions are taken or in the context of the EU Regulation
the place from where the corporate entity is effectively 1346/2000 relating to international
managed. The concept of COMI is therefore very close to insolvency proceedings, as the
the real seat doctrine, which is applied in Luxembourg law. location of the COMI determines the
The COMI or the real seat are determined pursuant to a jurisdiction and the governing law of
range 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, place
where the accounts of the company are drawn up. As a result, the COMI may be regarded as having
been transferred to another jurisdiction if one or several of these elements are located in that
jurisdiction. 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 foreign
jurisdiction. Pursuant to the EU Regulation 1346/2000 relating to international insolvency proceedings
this would mean that those assets would be part of the assets subject to the main insolvency
proceedings opened in that jurisdiction. On the other hand, the pledged assets are regarded as still
being located in Luxembourg, such assets would not be subject to main insolvency proceedings and
secondary insolvency proceedings should be opened in Luxembourg in respect of those specific
assets. In that case, the Luxembourg court having jurisdiction over such secondary insolvency
proceedings will fully recognise the waterproof effect of the Luxembourg financial collaterals.

In the context of the contemplated enforcement Luxembourg financial collaterals and with the
intention of escaping the Luxembourg law insolvency waterproof effect, the transfer of the COMI has
been successfully performed in the famous Coeur Défense case: the French court admitted that the
company, which had its registered office in Luxembourg, actually had a French COMI and therefore
filed the company under the protective French mesures de sauvegarde, which meant that the pledgee
was 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 have
devastating effects in respect of the enforceability of Luxembourg financial collaterals.


 Counter-Measures

Among a series of counter-measures aiming at preventing the risk of transfer of the COMI out of
Luxembourg as the main measures should consist in giving to the Luxembourg entity as much as
substance as possible. Whilst the substance is well-known to tax practitioners, it was somewhat
overlooked in terms of the security package and that concern must be therefore seriously
reconsidered. 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-measures
may also be considered, such as the registers (shares, bonds, hybrid instruments, receivables) held in
escrow in Luxembourg.


CONTACT


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:
daniel.boone@wildgen.lu david.maria@wildgen.lu


The Moneychanger and his Wife, 1514
By Quentin Massys (1466 – 1530)
Louvre, Paris

The information contained herein is of a general nature and is not intended to address the circumstances of any particular
individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such
information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon
such information without appropriate advice after a thorough examination of the particular situation. Therefore, WILDGEN can
not accept any liability for any errors, omissions or opinions contained herein and for the implementation of the principles set out
without its active involvement.

Established in 1923

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L-2320 Luxembourg
Tel.: +352 40 49 60 1
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www.wildgen.lu

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Luxembourg Financial Collaterals 3rd Ed., June 2011

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