Recent changes in the European loan and claims trading market may impact future investment strategies for fund clients focused on the secondary loan market. From new laws allowing limited direct lending to Italian borrowers, as well as simplified procedures for transferring loans made to French borrowers, new opportunities for investors seeking cross-border credit exposure are increasing. Below are two new developments RK&O lawyers have been following and their recommendations for clients interested in these markets.
NEW LAWS ALLOW DIRECT LENDING INTO ITALY
In January of this year, Italy introduced new rules enabling direct lending into Italy by EU Alternative Investment Credit Funds ("EU AIFs") through the implementation of the "Italian Financial Act". The main objective of the new rules was to modernise the process for investment by credit funds, and to actively increase opportunities and direct investment in Italian credit.
More Modern Lending Practices
Lending activities in Italy were historically restricted to banks and financial institutions directly regulated by Italian authorities. This restriction covered not only primary lending, but also the purchase of loans in the secondary market. To circumvent this restriction, foreign financial institutions were forced to use complex fronting structures, often referred to as 'Italian Bank Lender of Record' ("IBLOR") structure, whereby funds were advanced to an Italian authorized lender who would in turn advance those funds to the Italian borrower. The IBLOR solution, however, was problematic in that it exposed the loan investor to the credit risk of both the underlying Italian borrower and the intermediating fronting bank. This structure also subjected the loan investor to other regulatory and tax risks.
The new regulations permit EU AIFs to engage in primary lending and secondary loan trading activity in Italy, subject to the following conditions:
- Lending/credit investment activity to Italian consumers is prohibited;
- The EU AIF must also be authorised to engage in lending/credit investment activity in its own EU jurisdiction of formation;
- The EU AIF must be a closed-ended fund, with rules and regulations similar to those of an Italian AIF (including the rules and regulations concerning financial leverage);
- The asset manager of the EU AIF must submit a notice to the Bank of Italy and receive their advance approval within sixty days to engage in the lending/credit investment activity. Once the sixty days have expired without any prohibition from the Bank of Italy (unless the Bank of Italy has excluded the notice period or requested investor information), the EU AIF may commence the credit investment activity; and
- The asset manager of the EU AIF must provide a statement of accounts to the Bank of Italy once the lending/credit activity has begun. There is an on going obligation of the EU AIF to ensure the Bank of Italy is kept up to date with any changes to its structure or status.
Withholding tax is no longer applicable to European banks, insurance companies based in the EU and institutional investors (e.g., AIFs, UCITS or pension funds) already authorised to lend into Italy.
Stamp duty was expanded to include an additional 0.25% charge on a facility amount on all medium to long term loans made by, not only banks, but also Italian securitisation vehicles, EU authorised insurance companies and investment funds established in the EU. However, stamp duty is typically paid only at the original syndication of the loans, and not due on the subsequent transfer in the secondary market, where the original parties paid the stamp duty. As a result, medium to long term loans (performing or non-performing) are attractive to investors so long as the tax requirements are met.
For clients interested in accessing the large Italian non performing loan market, or for those seeking to add Italian loans to their loan portfolio, it may be worth their time and effort to form a qualifying investment credit fund in the European jurisdiction of their choice. There are a number of steps in the process, including obtaining approval from the Bank of Italy, so advance planning is key for any investor wishing to enter the Italian loan market.
NEW FRENCH FORM OF ASSIGNMENT
In October of last year, Order n°2016-131 entered into force and amended the French Civil Code provisions governing French contract law. The reforms codified principles which have emerged from case law in the French courts and also created new rules applicable to legal contracts.
Despite concerns regarding the ambiguity of these reforms (including the lack of certainty in how the reforms will be adopted practically, as well as on-going questions of interpretation), they should largely improve and simplify the means of effecting legal transfers of loans and receivables under French law.
In particular, the reforms have introduced a new form of assignment (known as a II cession de contrat'') which purports to transfer an entire contractual relationship. This transfer mechanism assigns both the rights and obligations under a loan, and eliminates the need to transfer obligations under a separate agreement. As an alternative to this new form of assignment, the French Civil Code continues to permit assignment of rights only (the familiar II cession de creance"). which does not include any transfer of the related underlying obligations.
The Effect on Post-Closing Formalities
These reforms also changed the process of transferring a loan or receivable of a French borrower, and stream lined the related post-closing requirements under French law. For all credit agreements effective prior to 1 October 2016, notification of a loan transfer was required to be made to any French obligors using a French bailiff (Huissier de Justice). Previously, we advised clients that notification by French bailiff was recommended to ensure the buyer's security interests were enforceable against third parties. Under the new rules the Huissier notice requirement has been removed and the buyer is now only required to provide a simple notice of the loan transfer to the French obligors.
However, it should be noted that it is the effective date of the credit agreement, and not the effective date of the assignment, that determines whether or not the buyer is required to arrange notification by French bailiff. When transferring a loan under a credit agreement which was effective prior to 1 October 2016, we recommend that a buyer continue to use the form of transfer provided for in the underlying credit documentation, and to adhere to the notification process using a French bailiff.
Beware of Banking Monopoly Regulations
As a general rule for all investors who do not have a French banking licence, when purchasing a French term loan in the secondary market, we recommend that the transfer be structured by assignment rather than by novation. Although a term loan is typically fully-funded, a transfer by novation may be viewed as making a new loan to a French borrower. This could result in the transferee losing the priority attached to the collateral granted in relation to the loan, as well as potentially infringing upon the French banking regulations. Purchasing from a seller which is a French entity may also trigger a violation of such regulations, as it could be construed as a credit transaction entered into in France, bringing the transaction into the territorial ambit of the French banking regulations. In contrast, when purchasing a French revolving loan, a buyer should (except in very limited circumstances) acquire the loan by a participation structure in order to avoid breaching French banking regulations. Due to the fact that a revolving loan may result in the requirement that the lender fund the borrower in the future, it would be considered a new credit transaction requiring a French banking licence. Without a French banking licence in place, the buyer could be found in breach of the French banking regulations which may be a criminal offence, and the sanctions for which include fines of up to €375,000, as well as imprisonment for up to three years.
Although the exact impact of this new form of assignment has yet to be seen, it is good news for investors since this may simplify the process required to transfer such loans. However, French banking laws remain very restrictive, and require careful analysis before a non-French entity should consider closing any loan made to a French borrower by assignment.
The Loan Market Association (LMA) announced on 6 September 2017 that it intends to make a small number of revisions to some of secondary loan trading documents, including the (i) Standard Terms and Conditions for Par and Distressed Trade Transactions, (ii) Funded Participation agreements and (iii) User's Guide. The revisions are primarily in response to the newly effective ERISA rules which were introduced by the U.S. Department of Labor, and the LMA has released a supporting note explaining the background behind the changes to ERISA.
In addition to the ERISA update, the latest LMA revisions make clarificatory changes to the "Delayed Settlement Compensation" and "Settlement Amount calculation" provisions. For the Delayed Settlement Compensation provisions, the changes make it clear that any interest or recurring fees credited to the Buyer on the Settlement Date as delayed settlement compensation which subsequently becomes PIK interest is to be returned to (or "clawed back" by) the Seller. Under the previous LMA Standard Terms and Conditions the Seller's right to claw-back delayed settlement compensation payments only arose if the Seller made a demand to the Buyer for its repayment but the revised provisions now obligate the Buyer to repay any clawed back delayed settlement compensation either on demand from the Seller or when the Buyer becomes aware of such interest not being paid or becoming PIK Interest, whichever is earlier. This change was included because the Seller may no longer be in the credit and therefore would have no notice of any subsequent failure by the Borrower to pay (or conversion to PIK) of such interest. For the Settlement Amount calculation provisions, a minor clarification has been made so that where there has been a Permanent Reduction but the Traded Portion is fully unfunded, the currency of the unfunded commitment should be used for calculating the credit to the Buyer in the Settlement Amount calculation.
Additional revisions to the form of the LMA Funded Participation acknowledge the need of the Grantor to complete any necessary "know-your-customer" due diligence on potential purchasers of an existing participation using the form of Transfer Certificate annexed to the Funded Participation.