Luxembourg: Enforcement of security 

Standard Luxembourg security package

Acquisition finance transactions involve multi-layered corporate structures and are secured against the assets and cash flows of the target company as well as of the acquisition vehicle.

Given that a Luxembourg holding company generally does not have any operational activities, shares, receivables and cash in bank are the most important assets to cover.

Pledges are the common form of security for such movable property. They are governed by the Law of 5 August 2005 on financial collateral arrangements, as amended (the "Financial Collateral Act").

In this briefing, we will be focusing on the enforcement of pledges over shares.

Enforcement of the pledge

Trigger event

Parties may freely agree on the trigger event to enforce a pledge. In this respect, the Luxembourg courts confirmed the possibility to enforce a pledge in the absence of any payment default, in case of a breach of a financial covenant of instance, and without the need to accelerate the underlying debt obligations.

Exercise of the voting rights

Although such rights will often be retained by the security grantor until the occurrence of an event of default, voting rights can be contractually vested in the secured parties. By doing so, the security agent will be able to vote the pledged shares prior to any default or enforcement, for example, upon any of the following early trigger events:

• the opening of restructuring / insolvency proceedings in another country;
• a COMI migration; or
• any proposed amendment to the constitutional documents of the company impairing the secured creditors' rights in relation to pledged shares

and replace hostile directors with a view to the withdrawal of the detrimental decision.

Enforcement methods

The Financial Collateral Act provides for the following enforcement procedures:

• private sale at arms’ length conditions (conditions commerciales normales);
• appropriation;
• sale by public auction; and
• attribution in court.

A prior notice to the security grantor or the debtor is not required.

In practice, the main methods used by secured creditors to realise the security are the enforcement by means of private sale or the appropriation of the pledged assets.

• Private sale
  
  The secured creditor has the right to sell the pledged assets without prior court approval if the debtor is in default.
  
  The sale can either be effected by the pledgee itself or by the pledgor upon request of the pledgee.
  
  The law does not require the proceeding to a valuation of the pledged assets; the only requirement being that the sale be made "at arm’s length conditions" (conditions commerciales normales). The criteria of arm's length terms is usually defined in dissociation from an abuse, meaning that a sale is at arm's length terms if the conditions are reasonable in all circumstances and not obviously disadvantageous to the security grantor. However, reasonable circumstances do not imply that the sale must take place at the best possible price, since the other conditions of the sale shall also be taken into account. As guidance, a private sale would meet the "normal commercial test" when made at a price that a well-informed independent willing buyer would normally, under relevant market conditions and taking into account the information available at that time, accept to pay to a willing seller.
  
  Given that no valuation is legally required, the enforcement by means of a private sale is the quickest and potentially the less cost intensive method. On the other hand, this may leave the door open for the security grantor to challenge the sale.

• Appropriation
  
  The secured creditor can appropriate the pledged assets at a price determined pursuant to the valuation method that is agreed upon between the parties.
  
  The appropriation can be carried out:
  
  • before or after the valuation has been completed;
  • by the pledgee itself or by a third party (e.g. a special purpose vehicle wholly owned by the lenders).
  
  Unlike in the UK for instance, no share certificates or undated share transfer forms are handed over to the pledgee. The appropriation will require the sending of a notice to the company whose shares are pledged and to the pledgor informing them of the enforcement and requesting the company (through its legal representatives) to reflect the transfer of the pledged shares from the security grantor to the pledgee in its share register.

A creditor friendly environment

Enforceability of pledges in insolvency situation

Directors are legally required to file for bankruptcy within 30 days of the company meeting the two following cumulative requirements: (i) it is no longer able to meet current liabilities (cessation de paiements) and (ii) it has lost its creditworthiness. 

The acceleration of loans under a facility agreement will most probably trigger the fulfilment of these two criteria. 

The opening of a bankruptcy proceedings will deprive the company of the administration of its own assets and lead to the appointment of a bankruptcy trustee (curateur). It has also the effect of stopping all attachment or garnishment proceedings. 

However, in relation to the granting and the enforcement of security, the Financial Collateral Act disapplies both Luxembourg and other jurisdictions' laws relating to bankruptcy, liquidation, reorganisation or similar measures. As a result:

• pledges are valid and enforceable against third parties, receivers, liquidators or similar persons notwithstanding a reorganisation, insolvency, winding up proceedings;
• the assets subject to the pledge do not form part of the insolvency estate; and
• claw  back  period’s  principles  (période  suspecte)  are  not  applicable  vis-à-vis pledges governed by the Financial Collateral Act.

Such protection is set up as a Luxembourg loi de police (mandatory law) with extraterritorial scope and effect as it applies not only with respect to insolvency proceedings opened by Luxembourg courts but also to proceedings opened in foreign jurisdictions at the sole condition that the security grantor is established in Luxembourg.

Enforcement cannot be frustrated

In addition to the bankruptcy remoteness of Luxembourg pledges provided by the Financial Collateral Act, the Luxembourg courts confirmed that, in the absence of fraud, legal actions (in particular, summary proceedings) cannot be used to delay or frustrate the enforcement process of Luxembourg security interest.

In practice, a smooth enforcement will require the collaboration of the directors of the company whose shares are pledged, as the beneficiary of the pledge will need access to the corporate records of the company and in particular its share register to reflect the change of shareholder. In certain circumstances, court proceedings may have to be launched by the pledgee to obtain judicial support to finalise the enforcement process.  This could take the form of the appointment of an ad hoc administrator to update the share register and provide the new shareholder with the company's corporate records. Another approach would be to create a new share register.

Post-enforcement protection: the waiver of subrogation

Where a debt is discharged by a third-party, that person is entitled to recover from the borrower the amount it has paid to the lender- this is the right of subrogation.

In the context of a pledge over shares, the enforcement of the security would thus give rise to a claim to the pledgor against the borrower for an amount equivalent to the value of the shares appropriated. 

In order to avoid that the secured creditor takes control of an entity which is the debtor of its previous parent company and the detrimental impact that this would have on the value of the collateral, the Financial Collateral Act expressly provides that the security grantor can irrevocably waive in anticipation the right of subrogation or recourse it may have against the company whose shares were pledged; usually the borrower.

Lenders would be well advised to ensure that their security agreements contain such a waiver.

As we have seen, the Financial Collateral Act provides a high level of protection to creditors. Because creditor protection also facilitate the access to credit and the terms on which it is available, not only the lenders benefit from the strength of the Luxembourg legal system, but also the borrowers.