Security interests and guarantees

Collateral and guarantee support

Which entities in the organisational structure typically provide collateral and guarantee support for bank loan financings? Are there limitations on which entities in the organisational structure are permitted to provide such support?

In cross-border financing transactions, Luxembourg companies are often located in the upper part of the group structure and are required to provide security interests over their assets or provide guarantees in relation to the obligations of their direct or indirect subsidiaries.

From time to time, Luxembourg companies are involved in cross-collateralised transactions involving the granting of security interests or guarantees also for the obligations of their parent company or sister companies. In those situations, the ultimate corporate benefit of the grantor must be carefully scrutinised to ensure full enforcement of the security interests or guarantees.

Security interests over assets (rights in rem) are limited recourse to the extent they are limited to the assets over which a security interest is granted.

There may be limitations where cross-group guarantees or upstream guarantees are being granted. Luxembourg does not recognise the concept of a ‘group of companies’, and the interest of the corporate group is insufficient to justify and validate an upstream guarantee. Corporate benefit must be scrutinised on a case-by-case basis: the guarantor should have some personal interests in the guarantee, notably through its expected benefits, and the risks it may take should be commensurate with the benefit deriving therefrom. In addition, the financial exposure deriving from the guarantees should not exceed the financial means of the guarantor at the moment of granting the guarantee.

In practice, guarantors under cross-group guarantees tend to limit, however disputable, the contractual recourse to a certain percentage of the net asset (book) value of the grantor. If, at all, a limitation of a guarantee is to be included in the loan documentation, the guarantee should be based on the real value (and not the book value) of the assets, disregarding the then outstanding liabilities.

What types of obligations typically share with the bank loan obligations in the collateral and guarantee support? If so, are all such obligations equally and ratably covered by the collateral and guarantee support?

Luxembourg collateral will secure the secured liabilities or obligations as defined in the foreign law-governed loan documentation and, in general, follow the market practice of that jurisdiction.

Commonly pledged assets

Which categories of assets are commonly pledged to secure bank loan financings? Describe any limitations on the pledge of assets.

The main categories of assets commonly pledged to secure bank loan financings or debt issued to the public are the following:

  • real estate property; and
  • financial instruments (as defined in the Financial Collateral Law) (mainly comprising shares, bank accounts, bonds and receivables) comprising:
    • all securities and other instruments, including, but not limited to, shares in companies and other securities equivalent to shares in companies, participations in companies and units in collective investment undertakings, bonds and other forms of debt instruments, certificates of deposit, loan notes and payment instruments;
    • securities that give the right to acquire shares, bonds or other securities by subscription, purchase or exchange;
    • term financial instruments and instruments giving rise to a cash settlement (excluding instruments of payment), including money market instruments;
    • all other instruments evidencing ownership rights, claim rights or securities;
    • all other instruments related to financial underlyings, indices, commodities, precious metals, produce, metals or merchandise, other goods or risks; and
    • claims relating to the items described above or rights in or in respect of these items, whether these financial instruments are in physical form, dematerialised, transferable by book entry or delivery, bearer or registered or endorsable, and regardless of their governing law (eg, undrawn fund commitments from investors in a fund).

 

Luxembourg law does not provide for the creation of floating charges or debentures. It is, however, often the case in international transactions that a Luxembourg company grant a floating charge or a debenture over non-Luxembourg-located assets.

Creating a security interest

Describe the method of creating or attaching a security interest on the main categories of assets.

Pursuant to the Financial Collateral Law, securities over shares, claims and bank accounts must be granted contractually in writing; however, no notarial deed is required.

There are no particular taxes, costs or charges in relation to the creation of a guarantee or security interest. No stamp duty or similar tax or charge applies to the creation or enforcement of a security interest over movable assets, such as shares, bank accounts or receivables, nor are there any public registration requirements. However, to obtain a definite date, the lender or security agent can choose to voluntary register the security agreement with the Administration of Registration and Domains in Luxembourg.

Mortgages over real property are passed before a Luxembourg notary public in the form of a notarial deed and are subsequently registered at the mortgage registry. The registration is only valid for 10 years (but is renewable) and entails certain costs.

Perfecting a security interest

What steps are necessary to perfect a security interest on the main categories of assets? What are the consequences of failing to perfect a security interest?

Under Luxembourg law, the transfer of the possession (dispossession) of the assets over which the pledge is granted is a condition for the constitution of the pledge. Dispossession can be done in various ways depending on the type of assets to be pledged. Dispossession is also required to make the pledge enforceable towards third parties. The law of the pledgor’s jurisdiction may impose further perfection or notification requirements.

The dispossession of registered financial instruments whose transfer takes place by a transfer in the registers of the issuer (as this is the case with respect to the shares in public company limited by shares) may be established by recording the pledge in those registers.

A pledge created over shares in a private limited liability company must be notified to the company whose shares are pledged.

Unless the debtor whose claims are pledged is party to the pledge agreement, the pledge agreement must be notified to or acknowledged by the debtor. In the absence of notification, the debtor of a pledged claim may validly discharge his or her obligation to the pledgor as long as he or she has no knowledge of the mere conclusion of the pledge.

A pledge over bank accounts must be notified to and acknowledged by the account bank maintaining the accounts, which will waive its general right of pledge and other preferential rights it has pursuant to its general terms and conditions. A mortgage over real property must be registered at the mortgage registry.

Failure to comply with these provisions may jeopardise the enforceability of the security interest and its ranking towards third parties and other creditors.

Future-acquired assets

Can security interests extend to future-acquired assets? Can security interests secure future-incurred obligations?

The Financial Collateral Law specifically provides that a security over financial instruments can be granted over all collateral, whether owned by the collateral provider presently or in the future.

Luxembourg security interest can secure future-incurred obligations.

Maintenance

Describe any maintenance requirements to avoid the automatic termination or expiration of security interests.

Luxembourg security interests are accessory in nature and continue to exist as long as the principal claim they secure is in place. No maintenance is required to avoid automatic termination or expiration.

Mortgages over real property assets are an exception; those mortgages must be renewed every 10 years.

Release

Are security interests on an asset automatically released following its sale by the debtor? If so, are the releases mandated by law or contract?

Luxembourg security interests are accessory in nature and, hence, as long as the claim they secure remains in place, the security interests continue to exist in spite of a transfer of the pledged assets to another party. This transfer is customarily not authorised under the Luxembourg security documentation unless a specific ‘permitted disposal’ and related release of the security interest have been considered and agreed upon by the parties in the main finance documentation.

Non-fulfilment of guarantee obligations

What defences does a guarantor have against claims for non-fulfilment of guarantee obligations? Can such defences be waived?

Under Luxembourg law, a guarantor under a suretyship (cautionnement) within the meaning of articles 2011 et seq. of the Civil Code benefits from various defences for non-fulfilment of its guarantee obligations, in particular when the guaranteed obligations are challenged, and in particular in the following occurrences:

  • the borrower has not defaulted under the loan agreement;
  • the lender has not satisfied its own obligations under the loan agreement; or
  • the guaranteed obligations are null and void.

 

The large contractual flexibility of Luxembourg law allows the waiver of defences or objections by the guarantor in relation to the payment of the guaranteed obligations under the suretyship.

In the case of a first-demand guarantee (garantie à première demande), the guarantor undertakes to irrevocably guarantee the secured obligation up to a fixed sum, irrespective of the secured obligations. This payment obligation is abstract and independent from any objection that can be raised with respect to the validity or enforceability of the guaranteed obligations.

The Luxembourg Parliament adopted on 10 July 2020 a new law relating to professional payment guarantees (the PPG Law), which creates a new type of guarantee that can be granted in a professional context. The objective of the PPG Law is to add, alongside the suretyship and the first demand guarantee, a new type of guarantee that allows greater contractual freedom while reinforcing the legal certainties among the parties. Under the PPG Law, unless otherwise agreed, the guarantor is not entitled to raise any defence in respect of the guaranteed obligation.

Parallel debt requirements

Describe any parallel debt or similar requirements applicable in a secured bank loan financing where an agent acts for multiple investors.

The Financial Collateral Law specifically provides that a security over financial instruments can be granted to an agent or a trustee acting for itself and for the benefit of all lenders, to secure the claims of third-party beneficiaries, present or future, provided such third-party beneficiaries are determined or determinable. Hence, there is no need for a parallel debt mechanism in relation to a pledge created over financial instruments.

To the extent a mortgage over real property is granted in favour of a security agent or trustee, parallel debt provisions are required. Such parallel debt will be the claim secured by the mortgage.

Enforcement

What are the most common methods of enforcing security interests? What are the limitations on enforcement?

The Financial Collateral Law provides that security interests in relation to financial instruments can be enforced as follows (with the first option being the most common one), unless otherwise agreed by the parties at the moment of contracting.

A notice prior to enforcement is not required:

  • to appropriate or cause a third party to appropriate the pledged assets at a price fixed, before or after their appropriation, according to the valuation method mutually determined by the parties;
  • to assign or cause the assignment of the pledged assets by private sale in a commercially reasonable manner, by a sale on the stock exchange or by public auction;
  • to obtain a court decision ruling that the pledged assets will remain in the party’s possession up to the amount of the debt, on the basis of an expert’s estimate;
  • in the case of financial instruments, to appropriate these financial instruments at the market price, if they are admitted to official listing on a stock exchange located in Luxembourg or elsewhere or are traded on a recognised, functionally operational regulated market that is open to the public or at the price of the last net asset value published, in the case of units or shares of a collective investment undertaking that regularly calculates and publishes a net asset value; or
  • the use of the capital call right by the security agent for the undrawn commitments against the investors in a fund.

 

Unless agreed otherwise in the financing documentation, a bank or credit institution will exercise a mortgage over a real property by appointing a notary public to organise the sale of the real property through a public auction. In the event the mortgagor is declared bankrupt, the court-appointed receiver will organise the sale of real estate.

Fraudulent conveyance and similar doctrines

Describe the impact of fraudulent conveyance, financial assistance, thin capitalisation, corporate benefit and similar doctrines on the structure of bank loan financings.

Financial assistance

As a general principle, it is unlawful for a Luxembourg limited liability company incorporated in the form of a public company limited by shares or in the form of a partnership limited by shares to provide financial assistance (advance funds, grant loans or provide security) for the acquisition of its own shares by a third party. Luxembourg law does not elaborate further on what constitutes prohibited financial assistance.

Prohibited financial assistance does not apply to transactions undertaken by banks and financial institutions in their ordinary course of business or to transactions in which shares are acquired by, or for the benefit of, employees.

A breach of the financial assistance prohibition may result in civil and criminal liability for the target’s directors. Third-party lenders may face civil liability and the transaction may be annulled.

Financial assistance is however allowed, under article 430-19 of the Law of 10 August 1915 on commercial companies, as amended, provided the company complies with the whitewash procedure, which requires, among other things, sufficient distributable reserves at least equal to the amount of the financial assistance granted, approval from the shareholders and the inclusion of the amount of the financial assistance as a non-distributable reserve (liability) in its accounts.

The Luxembourg law of 6 August 2021 amending the Law of 10 August 1915 on commercial companies, as amended, clarified that the prohibition of financial assistance does not apply to Luxembourg private limited liability companies.

 

Cross-stream and upstream guarantee

In cross-border financing transactions, Luxembourg companies are often located in the upper part of the group structure and are required to provide security interests over their assets or provide guarantees in relation to the obligations of their direct or indirect subsidiaries.

From time to time, Luxembourg companies are involved in cross-collateralised transactions involving the granting of security interest also for the obligations of their parent company or sister companies. In those situations, the ultimate corporate benefit of the grantor must be carefully scrutinised to ensure full enforcement of the securities.

Security interests over assets (rights in rem) are limited recourse to the extent they are limited to the assets over which a security interest is granted.

There may be limitations where cross-group guarantees or upstream guarantees are being granted. Luxembourg does not recognise the concept of a ‘group of companies’, and the interest of the corporate group is insufficient to justify and validate an upstream guarantee.

In practice, guarantors under cross-group guarantees tend to limit, however disputable, the contractual recourse to a certain percentage of the net asset (book) value of the grantor. If a limitation of a guarantee is to be included in the loan documentation, the guarantee should be based on the real value (and not the book value) of the assets, disregarding the then outstanding liabilities.

 

Corporate benefit

The granting of a guarantee or security must meet the requirement of a minimum and adequate corporate benefit. The corporate benefit analysis must be considered on a case-by-case basis and be explicitly resolved by the board of managers or directors of the company (and also by the shareholders, if required by the articles of incorporation of the company).

 

Thin capitalisation

Luxembourg tax laws do not set any specific thin capitalisation rules in Luxembourg, and the amount of corporate debt financing is not subject to any strict debt-to-equity ratios, subject however to any anti-abuse or anti-simulation provisions.

Informal limits are, however, applied by the tax authorities for the financing of an acquisition of a subsidiary by intra-group loans. In this situation, the Luxembourg tax authorities generally consider a ratio debt-equity of 85:15 as being a safe-harbour ratio in line with the arm’s length principle, which means that up to 85 per cent of the purchase price of the participations can be financed by interest-bearing intra-group loans.

For the purpose of determining the debt-to-equity ratio, an interest-free loan from shareholders may be treated as equity for corporate income tax purposes, so it may be possible to structure funding with a 99:1 debt (interest-free or bearing)-to-equity ratio. A debt-to-equity ratio of 99:1 could also be achieved by using certain exit instruments, such as tracking loans. Funding structures should be analysed on a case-by-case basis. Any excess interest payments that result from an excess over the above debt-to-equity ratio would be reclassified as hidden profit distribution, subject to withholding tax at a rate of 15 per cent generally applicable on dividends payments, unless the recipient qualifies for the affiliation privilege in Luxembourg.

Interest rates of intra-group loans must be in line with the arm’s length principles evidenced by a transfer pricing report in accordance with transfer pricing regulations in Luxembourg, and in particular Circular L.IR. No. 56/1-56bis/1 dated 27 December 2016. Interests deductibility is also affected by the implementation of the Anti-Tax Avoidance Directives (ATAD Directives: ATAD 1- Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market and ATAD 2- Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries). 

ATAD 1 was implemented in Luxembourg as of 1 January 2019 and a new tax provision (article 168-bis L.I.R.) introduced a cap on the deduction of net financial costs, referred to as exceeding borrowing costs (EBC), up to a percentage of 30 per cent of fiscal EBITDA, while providing for a de minimis financial threshold allowing full deduction of EBC up to a limit of €3 million. The tax administration has issued an administrative circular on 8 January 2021 providing some guidance on its interpretation.  The Luxembourg law implementing the ATAD 2 introduced a provision addressing intra-EU hybrid mismatches with effect as from 1 January 2020 and a provision addressing third countries mismatches with effect from 1 January 2022. The Law replaces this provision by incorporating the broader anti-hybrid provisions of the ATAD 2, and adds a new provision addressing the taxation of ‘reverse hybrids’.

The exit of the United Kingdom from the European Union has not affected structure financing between Luxembourg and the United Kingdom, as the applicable zero rate withholding tax pursuant to the EU Savings Directive has been replaced by the provisions of the double tax treaty between Luxembourg and the United Kingdom, which provides for a full exemption on interest payments.

Finally, gross-up provisions are common in lending documentation, and the borrower is usually required to gross up its payment against any withholding tax that would apply on interest payments.

 

Clawback and fraudulent conveyance

Transactions can only be clawed back or challenged in a bankruptcy. A clawback is initiated by the receiver and debated in court. Only specific transactions can be challenged.

Transactions entered into during the hardening period – fixed up to six months before the bankruptcy judgment – and up to 10 days before this period may be declared invalid if they constitute the preferential satisfaction of one creditor over another.

The court can cancel the following transactions:

  • disposal of assets without adequate consideration;
  • payments made for debts not yet due;
  • payments of due debts by means other than cash or bills of exchange; and
  • granting of any security for a debt contracted before the hardening period.

 

Any payment for accrued debt or any transactions against money made after a company has ceased its payments and before the bankruptcy judgment may be cancelled by the court if the beneficiary of the payment or the contracting party was aware of the debtor’s cessation of payments.

Mortgages granted during the hardening period (or 10 days before) may be cancelled if their registration has not been performed within 15 days of the conclusion of the mortgage agreement. Payments made in fraud of creditors’ rights are void irrespective of the day they were made.

The rights of creditors benefiting from a security governed by the Financial Collateral Law, even granted during the hardening period, are not affected by bankruptcy or reorganisation proceedings and, therefore, remain enforceable.