A recent Luxembourg District Court judgment(1) has confirmed the great flexibility offered by the Luxembourg act (August 5 2005) on financial collateral arrangements, as amended (the Collateral Act), to creditors to enforce their Luxembourg law governed pledges. In particular, the court ruled that a Luxembourg pledge can be enforced by a creditor on the occurrence of a contractually agreed enforcement event, without requiring repayment or the need to accelerate the underlying debt obligations.
In 2011 a Luxembourg investment fund (the pledgor) acquired through a Luxembourg private limited liability company the majority of the shares (53.07%) of the holding company of a French group of companies operating a chain of grill restaurants in France.
To refinance the French group's debt, three senior bonds maturing in March 2019 were issued by three issuers forming part of the French group and were subscribed by the same private equity firm (through various group companies) (the lenders) for an aggregate amount of €160 million (the senior bonds).
The senior bonds were secured by several security interests, particularly by the following Luxembourg law governed pledge agreements granted by the pledgor to a collateral agent, acting for the benefit of the lenders (the collateral agent):
- a share pledge over all the shares held by the pledgor in the Luxembourg company; and
- a bonds pledge over all of the subordinated bonds issued by the Luxembourg company to the pledgor.
Under the terms and conditions of the senior bonds, the French group undertook to comply with a certain number of financial ratios, particularly an actual financial gearing ratio. Unlike the other ratios, any breach of the actual financial gearing ratio constituted an "event of realization" under the terms and conditions of the senior bonds, leading to early termination and acceleration of the repayment of the senior bonds on written notice sent to the issuers. In addition, the pledges provide that they may be enforced in case of breach of the actual financial gearing ratio or in case of payment default under the senior bonds. According to the lenders, the actual financial gearing ratio had not been observed by the French group since December 31 2013.
Active negotiations were thus initiated by the pledgor to obtain a waiver from the lenders of their right to demand early repayment of the senior bonds and to enforce their pledges. These negotiations led to a 'heads of agreement' executed by the lenders, but the issuers of the senior bonds refused to execute it. As a result, the lenders took action to enforce the pledges. On April 7 2015 the senior bond holders received two letters from the collateral agent notifying them of the enforcement of the pledges and the appropriation by a newly formed Luxembourg company, Newco, of all of the shares and subordinated bonds in the Luxembourg private limited liability company. Such appropriation allowed the lenders, through Newco, to take control of the French group and change its management.
The pledgor made an application before the court to challenge the enforcement of the pledges that it deemed unfair, illegitimate and unjustified based on:
- absence of any payment default and acceleration of the underlying debt;
- absence of breach of the actual financial gearing ratio;
- fraud; and
- abuse of law.
The arguments were all rebutted by the court.
Clearly established fraud The court confirmed the possibility to set aside the enforcement of a Luxembourg pledge, but only in case of clearly established fraud. The lenders objected to the annulment demand made by the pledgor that the enforcement of the pledges could not be set aside by a court and that the pledgor's claim was hence inadmissible in court.
The court stated that the Collateral Act allows the enforcement of a pledge without any judicial intervention, under the sole condition of apparent regularity. It specified that a pledgor cannot oppose any defences to such pledge enforcement and that the only remedy it has is an ex post liability claim.
However, the court held that a claim to set aside the enforcement of a pledge is admissible in case of clearly demonstrated fraud or abuse. It based its decision on a July 10 2013 Luxembourg District Court judgment (1089/13, Roles 120206, 121127 and 122468)(2) which held that the enforcement of a pledge, when exercised in bad faith, was of no use and that accordingly, the enforcement of a pledge can be declared void, as otherwise a pledgor would be deprived of any recourse.
Nevertheless, the court held that such a possibility is an exceptional breach of the principles set out by the Luxembourg courts and is foreseeable only if fraudulent intent is unequivocal.
In this case, the pledgor argued that the fraud from the lenders in enforcing the pledges was clearly demonstrated, as their only intention had been to take control of the French group, not to obtain repayment of the senior bonds. Further, the pledgor claimed that the lenders had held negotiations regarding the refinancing of the French group in bad faith and had had no intention to come to an agreement, as their aim had been to gain time to prepare the enforcement of the pledges.
The court ruled that there had been:
- no fraud, as there was no malicious intent; and
- no bad faith or unfair appropriation of the pledged assets, as the provisions of the pledge agreements were strictly followed by the collateral agent.
The pledgor thus failed to demonstrate the lenders' fraudulent intent.
Breach of financial covenant The court confirmed the possibility to enforce a Luxembourg pledge without any payment default and in case of a breach of a financial covenant. In the case at hand, despite the breach of the actual financial gearing ratio, the lenders did not call for an early termination of the senior bonds or declare their early maturity, but instead enforced the pledges.
Without any payable debt, the pledgor asked the court to annul the enforcement of the pledges.
The pledgor argued that the nature of a pledge is to be ancillary to the relevant secured obligations and that its sole aim is to secure the repayment of the underlying debt. According to the pledgor, the enforcement trigger of the pledges must relate to an event of default leading to an acceleration of the underlying secured obligations.
Based on the terms of the pledge agreements – under which a breach of the actual financial gearing ratio constitutes an event of realisation – and on the provisions of the Collateral Act, the court concluded that the pledge agreements could be validly enforced by the collateral agent even though the secured debt was not yet due and payable.
The court ruled that the parties may freely agree on the trigger event to enforce a pledge based on Article 1(6) of the Collateral Act, which provides that an 'enforcement event' means that:
"a default or any similar event as agreed between the parties on the occurrence of which, under the terms of the financial collateral arrangement or the relevant financial obligation agreement or by operation of law, the collateral taker is entitled to realise or appropriate the financial collateral."
The law permits the enforcement of a pledge absent any debt being due.
Consequently, the court ruled that a breach of the contractually agreed actual financial gearing ratio was a valid enforcement event. Based on Article 11 of the act, the court concluded that there was no need for any preliminary notice or indication of the relevant enforcement event to enforce the pledges.
Although such a possibility was contained in the act, the right to enforce a pledge when the secured obligations are not yet due and payable has been debated between legal scholars(3) and the judgment has been welcomed by legal practitioners.
Abuse of law The court clarified the concept of 'abuse of law' in the context of a pledge enforcement. The pledgor claimed that the lenders' intention had not been to obtain repayment of their debt, but to take control of the French group and change its management as the lenders had not requested the repayment of the senior bonds before enforcing the pledges.
In addition, the pledgor argued that an abuse of law was also established by the manifest disproportion between the prejudice allegedly suffered by the lenders and the prejudice actually suffered by the pledgor, since there was only a technical breach and no payment default.
The court ruled that the appropriation of the shares and bonds of the Luxembourg company by Newco was not diverted from its purpose. It was therefore not abusive since such enforcement had been made by the lenders to restructure and recapitalise the French group in order to ultimately have its debt repaid.
The court noted that the collateral agent had appointed an audit firm to value the pledged assets after the appropriation in accordance with the pledge agreements and the Collateral Act, and ruled that there was no abuse in the valuation of the pledged assets. In any case, the court ruled that even though an abuse would exist in the valuation of the pledged assets, it would not affect the enforcement of the pledge (ie, only damages could be obtained).
The judgment once again confirms the well-established, flexible and creditor-friendly environment offered by the Collateral Act.(4) The Luxembourg judges ruled that the enforcement of a pledge cannot be set aside, except in the case of clearly established fraud. The main takeaway from the court's decision is the confirmation of the possibility offered by the act to enforce a pledge without any payment default and in case of a breach of a financial covenant.
For further information on this topic please contact Josée Weydert or Nicolas Bonora at NautaDutilh Avocats Luxembourg Sàrl by telephone (+352 26 12 29 1) or email (firstname.lastname@example.org or email@example.com). The NautaDutilh Avocats Luxembourg Sàrl website can be accessed at www.nautadutilh.com.
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