Paris Banking Newsletter

This month we look at the impact of the reform of the audit market on loan documentation.

1. Auditor choice provisions in loan documentation

The legislative package for the reform of the audit market in the European Union ("EU") entered into force. There is a two-year transition period which means that most of the key provisions are expected to become applicable in the 28 EU Member States on 17 June 2016. However certain prohibitions affecting loan documentation will apply to both new and existing contracts.

The legislative package consists of:

• Regulation (EU) 537/2014 of 16 April 2014 (the “Regulation”) on specific requirements regarding statutory audit of public-interest entities ("PIEs") (such as listed companies, credit institutions and insurance entities); and
• Directive (EU) 2014/56 of 16 April 2014 (the "Directive") amending Directive 2006/43/EC on statutory audits of annual accounts and consolidated accounts of all types of audited entities (including PIEs).

What are the main objectives of the reform of the audit market?

The purpose of this legislative package is to remedy weaknesses of the audit services market highlighted by the financial crisis and to restore public confidence in financial information. In particular, the aim is to:

• improve audit quality by increasing the informational value of the audit report;
• prevent conflicts of interest and reinforce independence by prohibiting the EU audit firms from providing certain non-audit services including tax advisory services; and
• improve transparency and competition by opening up the audit services market to small and mid-tier firms.

What are the impacts on borrowers and loan documentation?

Contractual provisions restricting the choice of auditors to "certain categories or lists of statutory auditors or audit firms as regards the appointment of a particular statutory auditor or audit firm to carry out the statutory audit of that firm" are prohibited and will be null and void (article 37 paragraph 3 of the Directive 2006/43/EC as amended), regardless of whether the undertaking is a PIE or not.

In principle, this EU ban applies only to audits of annual or consolidated accounts as required by EU law (or, in some circumstances, in accordance with national law).

“Big Four only” clauses requiring that the audit be done by one of the “Big Four” firms (Deloitte, KPMG, PwC or Ernst & Young) falls within the scope of the EU ban. It will apply to existing transactions as well as those entered into after the ban takes effect. The ban will be required to take effect no later than 17 June 2016.

Under article 16 paragraph 6 of the Regulation, PIEs will also be obliged as from 17 June 2017 to report any attempt by a third party to impose such a contractual clause or to "improperly influence" their choice of auditor.

Consequently, the LMA amended the auditor provisions set out in the standard form leveraged documentation and commodity finance documentation which, until that date, contained a “Big Four only” clause.

What are the LMA formulations of the auditor choice provisions?

The LMA's existing auditor control provisions are replaced with two options in relation to the Parent's auditors as follows:

• where the EU ban applies, auditors are defined as: the Parent's current auditors or any other firm appointed by the Parent to act as its statutory auditors; or
• where the EU ban does not apply: the Parent's auditors are either a specified firm or firms or any other firm approved by the Majority Lenders (such approval not to be unreasonably withheld or delayed).

By giving the Parent the freedom to choose its statutory auditor, the LMA's new wording prevents lenders from having a degree of qualitative control over the borrower's choice of auditors. However, lenders are generally concerned about the skills and expertise of the borrower's auditors and want to ensure that the auditing standards of such auditors are of a high quality.

To address this concern, the LMA introduced the optional concept of "Monitoring Accountant" (being a named firm or firms or any other firm approved by the Majority Lenders (such approval not to be unreasonably withheld)) to carry out the report on compliance with financial covenants.

However, a borrower may not be willing to incur the cost of a different Monitoring Accountant to its statutory auditor and it is unclear whether this mechanism might be seen as a de facto restriction on the choice of statutory auditors or an attempt to exert "improper influence". The LMA pointed out that their proposed wording is not risk free.

Where does the market stand?

A few months after the LMA's drafting proposal, it seems that the definition of Monitoring Accountant is not included in loan documentation. Various stakeholders have different views and have developed their own wording. The issue will need to be reconsidered once France has enacted implementing measures.

2. On your radar

French preventive and insolvency proceedings have been the subject of numerous changes over recent years and are becoming more creditor-friendly. Under article 70 of the so-called "Macron" draft bill, currently being discussed before the Senate, a court can, under certain circumstances, evict shareholders who refuse to support a reorganisation plan which affects the share capital of a company.

Such an eviction would entail a forced sale of that shareholder's equity interest to parties who support the reorganisation plan. There are conditions to such a forced dilution or eviction namely: the company must meet certain thresholds (e.g. number of employees) the court must be of the view that the company ceasing to operate as a going concern would cause serious damage to the national or local economy and modification of the share capital of the company must be the only realistic alternative to such cessation of activity.

While market practitioners have been calling for an ambitious reform of French bankruptcy procedures, the proposed text has raised concerns. Commentators welcome the eviction threat, which will force reluctant shareholders to sit at the table to avoid the closing down of the company, but many question the criteria which will be used by the court to evict shareholders. The main weakness, according to some commentators, is that the court will have too much wide discretion and will not have to take into account the value of the company when exercising its authority. They fear that in some instances this may result in an arbitrary, and economically unjustified, deprivation of the shareholders' property rights. This deprivation also raises issues of constitutionality and the French Constitutional Council (Conseil constitutionnel), the court responsible for assessing the constitutionality of legislation, is highly likely to be seized of the text prior to its enactment.

The draft bill also provides for the creation of commercial courts which will be dedicated to preventive and insolvency proceedings.

3. What’s next?

Our next newsletter will focus on the recast of Brussels I Regulation (on jurisdiction and the recognition and enforcement of judgments) and recent French case law relating to asymmetric jurisdiction clauses.