Enforceability of capital commitments in a subscription facility
01 September 2023
01 September 2023
1. Subscription credit facilities are secured by the right to call on and receive the unfunded capital commitments of the fund’s investors.
Since the lender’s recourse is limited to the commitments, the investors' funding obligations and the level of protection granted by the security have to be carefully considered.
2. When contemplating extending a subscription line facility to a fund established in Luxembourg, a lender will want to know the following:
(a) Is a security over the investor's uncalled capital commitments permitted?
(b) Is that security interest enforceable and, if so, how?
(c) What is my recourse against a defaulting investor?
3. An investor's capital commitment is an undertaking to contribute a certain amount of capital to a fund or, where applicable, to subscribe for a certain number of shares/units in the fund.
In a recent decision, the Luxembourg Court of Appeal analysed the legal nature of an undertaking to subscribe for shares in a public limited liability company:
[…] the word "subscription" refers to the act by which an investor makes a promise to acquire shares in a company, while "liberation" refers to the shareholder's obligation to make available to the company the money or goods in kind to which he or she committed at the time of subscription. The two actions do not necessarily take place at the same time
The word "subscription" thus has two aspects: on the one hand, and above all, it expresses an obligation which establishes the debtor's status as a partner; but, on the other hand, this term refers to a material result: the collection, not the payment, of all the contributions that make up the company's capital; thus, for cash contributions, a distinction must be made between the promise to make the contribution (subscription) and the fulfilment of this promise, i.e. the actual payment of funds into the company's treasury (payment) (Jurisclasseur, Sociétés, Fasc. 114-10 Sociétés par actions, Constitution, Souscription des actions, no. 2). [Cour d'Appel, Luxembourg, 02/02/2021 No. CAL-2019-00190 and CAL-2019-00370)]
This obligation to pay the committed capital resulting from the subscription agreement forms the basis of a claim of the fund against the investor. This claim will be crystallised by the delivery of a drawdown notice to the investor and can be pledged in accordance with the law of 5 August 2005 on financial collateral arrangements, as amended (the "2005 Law").
4. Whether the fund is actually permitted to grant security over investors' uncalled capital commitments is principally determined by the terms of the fund's constitutional documents, typically the limited partnership agreement ("LPA") and, where applicable, its offering memorandum.
In addition, the LPA and the management agreement(s) define the general partner's powers and rights to issue drawdown notices and state whether those powers and rights have been delegated to an alternative investment fund manager or an investment manager.
Side letters between the fund and its investors should be carefully examined as they may contain restrictions on the ability of the fund to pledge the capital commitments of certain investors or excused investor provisions, which excuse certain investors participating in certain investments. Tax, regulatory or ERISA reasons may also prevent a feeder fund from granting direct security to a lender if the purpose is to support the main fund’s obligations under a subscription facility.
5. Enforcement of security granted under the 2005 Law may be effected by one of several methods provided under the law itself, or as contractually agreed in the Luxembourg security documents.
The 2005 Law expressly provides that a pledge of claim implies the right of the collateral taker to exercise the rights of the security grantor linked to the pledged claim (article 5(4)). In this respect, it is widely recognised that the power to make a capital call on investors' undrawn commitments constitutes an ancillary right to the fund's claim to the capital commitments.
6. Certainty for secured parties is enhanced by the 2005 Law's disapplication of the laws of both Luxembourg and other jurisdictions relating to bankruptcy, liquidation, reorganisation or similar measures and the terms of any civil, criminal or other judicial attachment or confiscation court order. In the absence of fraud, all legal risks of nullity of security (claw back) or unenforceability (stay of enforcement) are disapplied, thereby making the security granted under the 2005 Law insolvency remote. The secured assets fall outside the bankruptcy estate of the grantor.
7. In an enforcement scenario, the secured party will now be able to deliver drawdown notices to the investors instead of the fund's general partner (or, depending on the terms of the fund documents, the fund's manager). But what if an investor refuses to comply with a drawdown notice?
8. Along with the right to make a capital call, a secured party will also have the right to enforce the obligations of the investors to fund the capital commitments.
The subscription agreement is the key document in terms of contractual obligations and liability; it is the only document signed by both the investor and the fund and it is the agreement that actually gives rise to the investor's commitment to subscribe for units in and pay into, the fund. The subscription agreement between the parties is legally binding. However, the enforceability of a capital commitment depends in large part on the payment obligation defences available to the investor.
In this respect, a lender will want to ensure that the fund documentation contains provisions that expressly waive investors' rights of set-off, counterclaim and defence, as well as any other right of exception or excuse they have in relation to the fund that may adversely impact a secured party's ability to call on and recover the investor's commitment. Alternatively, if this isn't provided for in either the LPA or the subscription agreement, it may be dealt with by way of an investor letter or an acknowledgement by the investors of a notice of pledge.
Such waiver will be irrevocable if it is properly drafted in the form of a third party beneficiary provision (stipulation pour autrui) and acknowledged by the secured party.
9. The fund's constitutional documents will set out the remedies available to the general partner against a defaulting investor. They include, among others, the ability to release the entire commitment and to exclude the investor from any distribution, to charge default interest or, in the worst case scenario, to compel the investor to sell its interest.
The Luxembourg courts handle a limited number of disputes between funds and investors. Published case law indicating such remedies are likely to receive a sympathetic hearing in Luxembourg is therefore rare. In terms of limited partnerships, the Luxembourg company law expressly provides that the LPA may authorise the management or the partners to reduce or redeem all or part of the limited interests of one or more partners and to determine the terms of such reduction or redemption.
Whilst the defaulting investor provisions contained in the LPA are useful in terms of management of the fund prior to an enforcement event, the purpose of such provisions is ultimately to deter investors from failing to meet their funding obligations rather than to obtain payment from the recalcitrant or defaulting investors. In practice, a secured party will seek to compel the investor to pay its capital commitment.
10. However, the nature of an investor's contractual obligation to contribute and pay down its capital commitment could have a bearing on the types of remedies available against it in the case of default.
If capital commitments usually take the form of an obligation to pay, such a commitment could be construed as an obligation to do or perform in certain cases, eg when it is drafted in the form of an undertaking to subscribe for new shares/units in the fund. While the natural remedy for an obligation to pay is specific performance (ie the right to force the debtor to comply with its obligations), in the case of an obligation to perform, article 1142 of the Luxembourg civil code provides that a breach will generally result in the payment of compensatory damages. When the capital commitment of an investor takes the form of an undertaking to subscribe, it is worth requiring that investors expressly waive the application of the provisions of article 1142 – in either the LPA, subscription agreement or an investor notice. French courts have recognised the validity of such waiver.
Another potential pitfall is when the obligation to fund takes the form of an undertaking to subscribe with a corresponding obligation for the fund to issue new shares. This is generally the case when the fund borrower is established as a société anonyme (public limited liability company, or SA) or a société en commandité par actions (corporate partnership limited by shares, or SCA)
A capital commitment structured in this way may prove harder to enforce, as a secured party will need to be able to satisfy the obligation of the fund to issue the corresponding shares to the investors. Luxembourg case law recognises the exception of non-performance (exception d’inexécution), meaning that, if it is clear that a party will not perform its obligations and that the consequences of such non-performance for the other party are sufficiently serious, the latter will be allowed to suspend the performance of its own obligations. If no shares can be issued in consideration for its investment, there is a higher risk that an investor will argue that its payment obligation has no cause and is thus not enforceable. One way of reducing this risk would be to use a capital call structure involving the issue of partly paid-up shares. A waiver of defence will also be required.
11. If so provided in the LPA, another option to bypass the lengthy process of enforcing the defaulting investor's payment obligation, is for the lender to rely on the overcall provision and call capital from the other fund's investors to cover the shortfall created by the defaulting one.
The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying it to specific issues or transactions.