Banking update. Senior covenant-lite facilities in the Euromarkets

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1 Senior covenant-lite facilities in the Euromarkets Since their introduction in the context of the Trader Media and World Directories deals in March and May of this year, so-called covenant-lite senior leveraged loans in Europe have received unprecedented coverage. Not only has this term been used by leveraged finance desks, sponsors and their lawyers, but the debate surrounding covenant-lite loans has continued into the national press, before Parliamentary select committees and in FSA briefings. The FT has predicted that the use of so-called cov-lite deals is snow-balling in Europe and the US, in spite of warnings from regulators. However, more recently, following concerns over the sub-prime US mortgage market and associated factors, both the US and European markets have seen some initial signs of turbulence making the future of covenant-lite more difficult to predict. Unfortunately, covenant-lite in the European context is not a term of art and as such has come to be used to describe very different types of leveraged deal. Seemingly the only similarity between deals called covenant-lite is that they include less than four financial covenants (as was previously typical in senior leveraged deals). However, in relation to both the number of financial covenants (two, one or none) and in relation to the other covenants more generally, covenant-lite structures vary materially from deal to deal. This article seeks to provide an overview of the three main types of covenant-lite structure currently seen in the European market. The first type is where the market has moved towards a reduced number of financial covenants, whereas the second and third types contemplate material additional flexibilities for sponsors more generally (in addition to the absence of financial covenants). Contents Senior covenant-lite facilities in the Euromarkets 1 What is Islamic finance? 5 The case of the disappearing guarantee: A real estate judgment with broader relevance? 9 Overview of acquisition finance structures in India 12 Are your endeavours good enough? 15 Update on developments in UK withholding tax provisions and treaty lenders in syndicated loans 17 Recent US netting legislation marks further expansion of protections for non-debtor counterparties to financial contracts in bankruptcy 19 Cross-border financing: Taking security in Portugal 21 Covenant-lite in the European context is not a term of art and as such has come to describe very different types of leveraged deal. June 07

2 Before covenant-lite - the traditional European LBO covenant package Prior to the introduction of covenant-lite into the senior European leveraged loan market, lenders had a number of covenant protections including the following: - Financial covenants: These would typically comprise four financial covenants: - a leverage ratio (debt to EBITDA); - an interest cover ratio (EBITDA to interest cost); - a cashflow cover ratio (cashflow to fixed charges (i.e. interest cost and scheduled principal amortisation)) - this covenant provides protection additional to the interest cover ratio in particular when there is amortising senior debt; and - a maximum annual capex covenant. Over the last months, the restrictive nature of these financial covenants has increasingly been relaxed through the introduction of additional headroom, financial definitions that permit a large degree of flexibility and equity cures. - Negative covenants with agreed caps: Negative covenants restrict the nature of the business (e.g. restricting acquisitions, joint ventures) and control over cash (e.g. loans out, guarantees, borrowings). These negative covenants are subject to specific exceptions and, for each, an agreed maximum cap. These are termed maintenance based (i.e. if the borrower maintains the level within the cap, there is no default) and compliance is tested throughout the life of the loan. The restrictive nature of these caps has to some extent been relaxed by the introduction of the right to carry forward annual caps from the previous year (where a cap was not used in full in the previous year) and of the right to carry back annual caps from the next period (where in a particular year a cap may be exceeded). - Security package including guarantor coverage: Security, subject to agreed security principles, is granted by material companies and (if required) additional companies to ensure that, say, 85 per cent. of all target group companies are granting security. All senior debt (term and revolving) ranks pari passu as to security proceeds. As with financial and negative covenants, there have been some further concessions made to sponsors in the context of the security packages and, in particular, limiting security to specific pre-agreed jurisdictions, expanding out the security principles (i.e. circumstances where security is not given) and reducing the security cover percentage. The first type - covenant loose Covenant-lite has been used (particularly in the press) to describe deals that are broadly the same as the traditional LBO covenant package described above but with a reduced number of financial covenants. - Format: These deals use the same format, negative covenants and other provisions of the traditional maintenance based LBO covenant package. - Financial covenants: These deals typically include no, one or two financial covenants. Most commonly these deals have at least one financial covenant (the leverage ratio). - Other covenants: In the context of these deals, a sponsor may be able to negotiate slightly better general covenant terms (e.g. no guarantor coverage test). However, these terms could equally be part of the negotiation in the context of a traditional LBO covenant package. As such, the only material difference between this sort of deal and the traditional LBO covenant package, is that there are fewer financial covenants. However, typically, these deals contain a leverage covenant and sometimes also an interest cover covenant. Furthermore, where an interest cover covenant is included and there is no amortising senior debt in the capital structure, it may not be so material to drop the cashflow covenant (as the cashflow covenant and the interest cover covenant end up testing the same financial performance point - i.e. the ability to pay interest). While a question of semantics, it is perhaps more appropriate to call these sorts of deal covenantloose, in particular where one or two financial covenants are retained. By contrast, the following two types of covenant-lite deal are significantly liteer in nature - not only do they typically contain no financial covenants, but the other general covenants include significant additional flexibilities for sponsors. The second type - US style covenant-lite The second type of covenant-lite European deal follows a similar structure to the US covenant-lite deals. As such, in addition to the absence of financial covenants, the information and other general covenants as well as 2 June 07

3 events of default broadly follow a traditional high yield covenant package. Certain key features include the following: - Format: The drafting of the covenant package in these deals follows the style and substance of high yield covenants. This is particularly helpful to the borrower where there is a high yield bond in the structure and the borrower is seeking to have a single set of covenants broadly apply across all layers of debt. - Non-amortising term debt: Usually, these covenant-lite senior debt structures do not include amortising debt as part of the senior term tranches. These senior term tranches are typically sold to funds and institutional investors that are familiar with these high yield covenant packages and are looking to invest in debt that is drawn in full during a short availability period and then remains outstanding until a bullet repayment. - Super-senior revolving debt as to security proceeds: In addition to the term acquisition facilities used to fund the purchase of the target, capital structures also contemplate undrawn debt - i.e. debt that either has a very long availability period and/or that can be drawn, repaid and redrawn). The best example of undrawn debt is working capital revolving facilities. Other examples of undrawn debt include capex or future acquisition facilities with longer availability periods. Undrawn debt will typically be sold to banks who are capable of holding undrawn commitments for longer periods and offering facilities that can be redrawn (as opposed to funds or institutional investors). These bank lenders would usually expect to lend against the more traditional full LBO covenant package. As such, in order to make the revolving (undrawn) debt more attractive to banks in the context of a US style covenant-lite package, typically the revolving debt is made super-senior, with first recourse to the security package. - Limited level of undrawn debt: For reasons described above, given that the revolving debt is super-senior, US style covenant-lite deals tend to limit the overall size of the undrawn debt. If the undrawn super-senior debt is particularly large, there may be a concern that this will affect the ability to sell the term acquisition debt as unsubordinated (because of the size of the undrawn revolving debt ranking ahead). In the European context, limiting the level of super-senior undrawn debt may be problematic where a sponsor is looking for large capex, acquisition, receivables lines and other undrawn debt tranches in addition to the revolving debt. In such circumstances in Europe, it may be appropriate to make the undrawn debt of equal ranking to the term debt and include a financial covenant as a concession to the undrawn bank lenders. - Financial covenants: Typically, there are no financial covenants. - Security package including guarantor coverage test: Typically, there is no guarantor coverage test and no further asset security is granted after the day one security package (on-going security is limited to security over shares in new material subsidiaries). - Negative covenants generally - incurrance style: The negative covenants are significantly less restrictive as compared to the traditional LBO covenant package. Rather than including caps (in particular in the context of restrictions on borrowings), US covenantlite deals use an incurrence ratio allowing for any restricted activity to the extent permitted by the financial incurrence ratio (such as a leverage ratio). In this manner, the debt incurrence test prohibits a borrower from incurring debt unless a leverage ratio (debt to EBITDA) is below a stated level - as such, as the EBITDA of the business improves, so more debt can be incurred. Where there is a subordinated debt layer (e.g. second lien or mezzanine), there may be two incurrence ratios - a senior debt ratio and a total debt ratio (and these will then limit how much additional debt can be incurred at each level in the capital structure). The covenant is not tested unless and until the borrower seeks to incur such debt, unlike a traditional LBO maintenance-based covenant. High yield bonds typically include this type of incurrence-based covenant. - Difference from high yield and US precedent: There are a limited number of areas where in Europe, the US style of covenant-lite deal offers the lenders additional protections (as compared to the US covenant-lite or high yield deals). In particular, US style European covenant-lite deals typically include the requirement for monthly financial reporting, an annual budget, and mandatory prepayments from part of any IPO proceeds and sweeps of excess cash. The third type - European covenant-lite Certain European based sponsors have pioneered a European style of covenant-lite deal by taking some of the flexibilities that are a feature of a US style deal, but drafting them within the context of what would otherwise be a traditional European LBO loan agreement. This type is in form similar to covenantloose deals, but in substance introduces additional June 07

4 general covenant concessions borrowed from high yield and US style covenant-lite deals. Certain key features include the following: - Format: The drafting of these deals follows the style of traditional European leveraged loans. It is some times seen as an advantage to use a style of loan agreement that the European market is more familiar with whether this be in terms of sponsors existing standard form documents, European management teams using those agreements, European pension trustees and their lawyers looking at these provisions where relevant, or syndication through European leverage desks. - Debt package: The super-seniority structuring issues that were relevant to US style convenant-lite deals (descibed above) apply equally to this type of deal. - Financial covenants: Typically, there are no financial covenants. - A better deal for banks than US style covenant-lite?: These European style covenant-lite deals present in part a better deal for lenders than the US style covenant-lite deals (described above) in particular: - they include a more comprehensive suite of representations; - they include a more comprehensive suite of positive covenants (including, among others, authorisations, compliance with laws, environment, taxes, acquisitions, disposals, pari passu, negative pledge, loans or credit, guarantees, security, financial indebtedness). US style covenantlite deals typically limit the number of positive covenants more narrowly to existence, conduct of business, payment of obligations, maintenance of properties, compliance with laws and insurance; - they include a more traditional European suite of separate negative covenants (limiting acquisitions, joint ventures, disposals, security, merger, indebtedness, loans out, guarantees, share issues, payments on subordinated debt) rather than the high yield style of negative covenants (which, for example, would limit loans out, guarantees out, payments to sponsors, acquisitions of minorities unless a single restricted payments covenant); - while the events of default for this type of covenantlite deal may be more limited as compared with traditional LBO deals (for example, there may be no MAC event of default), they may, however, be more comprehensive than events of default in US style covenant-lite deals (which typically do not include a MAC event of default, audit qualification or breach of intercreditor events of default). - Negative covenants generally: In the context of European covenant-lite deals, while the negative covenant restrictions themselves are based on the form of traditional European LBOs, the exceptions to those restrictions (i.e. what the sponsor is permitted to do) are in places very different, and incorporate most of the flexibilities and exceptions contemplated in the US style deals. Furthermore, there are limited examples in these European covenant-lite deals where the exceptions not only incorporate flexibilities US style covenant lite deals but also continue to include exceptions seen in the traditional LBO style deals. For example, in relation to debt in a business that has been acquired by the group, the US style would limit that debt by reference to an incurrence covenant; and by contrast the traditional LBO approach would not limit the level of debt but require it to be refinanced within a fixed period of time (say 6-12 months). European covenant-lite deals sometimes give the sponsors the option either to incur the acquired debt on the basis of an incurrence covenant (without the obligation to refinance) or to use the traditional exception and refinance within the timeframe (i.e. giving the sponsor the flexibility of both approaches). Looking ahead Already an increasingly common feature in the US, covenant-lite deals are now a hot topic in the European leveraged finance market. High liquidity in the market, coupled with the development of the secondary syndicated loan market and the rise of nonbank lenders (such as CDOs and hedge funds) in the European leveraged loan market in recent years have significantly changed, and continue to change, the terms on which finance is provided to borrowers. The meaning of the term covenant-lite in the European market is still evolving. Going forwards, it is likely we will continue to see a variety of types of covenant-lite deals in the market before a standard European covenant-lite package begins to emerge. Stephen Lucas, London 4 June 07

5 What is Islamic finance? Islamic finance is financing which conforms to the doctrines of the Islamic law known as Sharia a, meaning way or path. Sharia a regulates the relationship between a Muslim and God as well as between dealings with other Muslims. It extends to influence the banking and financial activities of Muslims. This article considers the underlying principles of Islamic finance and key instruments used in Islamic finance transactions. Innovative financing structures have been, and continue to be, devised...in order to permit Islamic banks and investors to participate in the global financial markets and achieve their commercial objectives in ways that are compatible with Sharia a. What is Sharia a law? Sharia a is not a codified system of law. The precept of Sharia a is very much dependent on the interpretations of the key Islamic principles. The sources of Sharia a (in hierarchical order) are the Qur an (the holy book), Sunna (the teachings and practices of Mohammed) and Ijtihad and Fiqh (Islamic jurisprudence). Fiqh (literally meaning knowledge or understanding of details ) is the interpretation of the Qur an and Sunna by Islamic jurists and scholars. There are four schools of thought on which jurists and scholars base their Fiqh. Underlying principles of Islamic finance There are a number of key concepts which are central to Islamic beliefs and must be borne in mind when structuring an Islamic finance transaction. The interpretation of those basic concepts may, however, differ according to the school of Islamic jurisprudence followed by particular Islamic banks and, accordingly, by their chosen Sharia a board/committee. Riba: Riba is most commonly understood as the prohibition of charging interest on lending money. However interest is only one component of Riba. The second component and the more complete Gharar: Maisir: definition of Riba is the prohibition of any increase or addition to money that is unjustified. Islamic principles require that any return on funds provided by the financier be earned by way of profit derived from a commercial risk taken by the financier. Any return on money cannot be for the mere use of money and as such any risk free or guaranteed rate of return on a loan or investment will constitute Riba and therefore be prohibited. Contracts containing uncertainty, chance or risk (Gharar) are prohibited under Sharia a law, particularly where there is uncertainty about the fundamental terms of a contract such as price, time, delivery and each party s obligations and rights. The Qur an prohibits any degree of uncertainty which would encourage speculation. So, for example, insurance arrangements would technically be thought of as Gharar as it involves paying a premium in respect of an event the occurrence of which is uncertain. However, as the Islamic counterpart to insurance, Takaful, is not as developed as common insurance and as many Islamic companies providing Takaful do not have the balance sheets of major insurance companies to provide the protection typically sought by conventional insurance, scholars have permitted the use of insurance in modern times until the Islamic alternative is available. Gambling (or Maisir) is prohibited in Islam, which leads to some contracts, such as contracts of futures and options, possibly being considered unacceptable as they could be used for speculative purposes. Bay Al-Dayn: This term means literally the sale of debt. Under Islamic law, the sale (transfer) of obligations or debt is prohibited and as such the buying and selling of promissory notes, for example, are generally prohibited, although some scholars authorise that if the sale is for face value (i.e. no discount). Prohibitions such as the above distinguish Islamic finance from conventional finance in several fundamental ways. Nevertheless, innovative financing 5 June 07

6 structures have been, and continue to be, devised by Islamic scholars and Islamic finance practitioners in order to permit Islamic banks and investors to participate in the global financial markets and achieve their commercial objectives in ways which are compatible with Sharia a. Key concepts - Islamic instruments There are several commonly used legal instruments recognised by Sharia a which are used as the building blocks for most Islamic structures. - Murabaha: Murabaha is the sale of goods at a price equal to original cost plus an agreed mark-up. In this type of transaction, an asset is purchased by a party (typically a bank) at the request of another party (the borrower) from a third party (i.e. a supplier) and then resold by the bank to the borrower at an agreed mark-up for immediate or deferred payment. The mark-up includes the purchase price and any other expenses incurred by the bank. For the contract to be valid, it must specify the quantity, quality and place of delivery of the asset, as well as the full price including the mark-up and the payment terms. - Salam: Salam is a sale agreement whereby the seller agrees to deliver the goods at a future date in exchange for full advance payment of the price. Although the goods need not exist, the general description, type and amount of the goods to be supplied as well as the date and place of delivery must be known at the time. The goods must also be of a type that is generally available in the market. - Istisna a: Istisna a is a contract whereby a party undertakes to manufacture or construct a specified asset according to agreed specifications at a determined price. In order for the contract to be Sharia a compliant, the price of the asset must be fixed at the time the contract is entered into and the specifications of the asset must be clearly stated. - Arboun: Arboun literally means advance payment, but is usually taken to refer to a specific type of sale contract whereby the purchaser pays a deposit forming part of the purchase price for the purchase of particular assets at a later date. If the purchaser does not proceed with the sale he forfeits the deposit to the seller. This type of sale agreement is controversial as many scholars cannot justify the forfeiting of deposit against no consideration other than either time or loss of opportunity both of which cannot be compensated for under Sharia a. However, the Islamic Fiqh Academy has permitted Arboun contracts, on certain conditions, including, if the timeframe of the contract is set and the down payment is considered as part of the selling price, if purchased. - Ijara: Ijara is a leasing contract whereby the owner of an asset (bearing all risks associated with the ownership of the asset) leases it to the lessee for a rent which is either agreed in advance or adjusted regularly throughout the lease period, either by consent, by reference to an expert or in some cases by reference to any interest-based index. Ijara would typically end by the lessee purchasing the asset on a specified date (maturity or full early prepayment). - Mudaraba: Mudaraba is a joint venture between two or more parties where one party (the Mudharib) contributes his effort and management skills and the other party contributes cash. The parties may share profits in any agreed proportions but losses can only be borne by the capital provider. The capital provider (Rabulmal) may not be entitled to claim a fixed amount as profit, however the percentage of the profit may be stipulated in the financing agreement (but not the amount) so that there is no guaranteed return for the investors with this type of financing. A Mudaraba can be for any term and can be used to finance any Sharia a compliant profit-making activity. - Musharaka: Musharaka is a joint venture between two or more parties with each party contributing to the capital of the joint venture (in cash or in kind) to invest the capital in a Sharia a compliant manner with a view to bearing losses and sharing profits resulting from such an investment. Profits may be shared in accordance with any agreed proportions. However, losses must be shared in proportion to shareholding. - Wa ad: A Wa ad is an undertaking or promise by one party in favour of another to perform a Sharia a compliant act such as selling or buying an asset on a future date or on the occurrence of a certain event. Using Islamic instruments in financing Structuring Sharia a compliant transactions usually requires using one or more of the above instruments or building blocks to achieve the required results. Set out below are two of the most common structures to achieve working capital/revolving loans and term loans. A. Revolving loan Murabaha is the most common manner for providing a working capital and revolving loan facility where there is no specific asset to be financed. In a typical 6 June 07

7 Sharia a compliant revolving facility, a commodity (typically metal represented by London Metal Exchange (LME) warrants) is bought by the bank from a supplier or broker and sold to the borrower for a deferred price equivalent to principal plus an agreed mark-up. On the repayment date a new Murabaha is entered into to achieve the revolving nature required. A traditional Murabaha transaction is Sharia a compliant because although the mark-up reflects a profit for the bank similar in commercial effect to an interest charge, the transaction involves the bank taking the risk of ownership upon purchase of the commodity until it is resold to the borrower. Even though the bank immediately resells the asset to the borrower, it does take title to the asset and therefore assumes the risk of loss, damage and storage of the asset prior to its resale to the borrower, thus justifying the return. Please see diagram A below. B. Term loan 1Sale Agreement 2 3 Murabaha Agreement Banks Company Deferred purchase price Spot payment Sale Agreement Spot payment Broker Diagram A: Murabaha The most common method of creating a medium to long-term loan is by using Ijara (leasing). In order for the bank to be able to charge rental it must own the asset. This is typically done by an outright sale of the asset to the bank by the borrower followed by the lease. Alternatively, where the borrower requires the loan for constructing or manufacturing an asset, the bank and borrower would enter into an Istisna a agreement requiring the constructing borrower to procure the construction of the asset. Upon completion of construction, a lease is entered into by the parties. Please see diagram B below. Given that during the construction period there is no asset that can be leased to the borrower, the bank cannot charge any rent during that period. However, some scholars approve the concept of forward lease agreement whereby the banks charge advance rental during the construction period. However, if an event of default occurs prior to completion of assets, the bank must return such advance rental to the lessee. Banks Lease Agreement Company Lease rentals Structuring issues Sale of asset/ Istisna a Purchase price Company Diagram B: Sale/Istisna a - Ijara Set out below are a few issues which may need specific consideration: - Title retention: In contrast to conventional financing structures, Islamic finance places considerable emphasis on the Islamic bank taking ownership risk so as to justify the generation of a profit. This emphasis on taking ownership creates exposures which would not usually be encountered when structuring other forms of debt financings. One way of dealing with this issue is adequate insurance cover. Another example is the danger that the application of local laws may result in the Islamic bank s loss of title, thus leading to termination of lease. For example, in some jurisdictions (e.g. in Germany), leased assets may become attached to land and title may, by operation of law, pass to the owner of that land. - Tax: The acquisition and purchase of assets to generate profit could potentially create exposure to capital gains, value added and documentary taxes or the ownership of an asset may be taxable or create tax residence issues. - Risk of loss: Sharia a requires that the risk of loss or destruction must lie with the Islamic bank and cannot be passed on to the borrower. In theory, there should be no indemnities in favour of the Islamic bank. However, in practice clauses are incorporated in agreements such as service agency agreements that have an effect similar to an indemnity on loss of asset. 7 June 07

8 - Insurance and maintenance risk: Sharia a requires that the responsibilities of properly maintaining and insuring a financial asset are to be borne by the owner of the asset which is typically the bank. This is contrary to the customary commercial approach in asset financing transactions, where maintenance and insurance are generally the responsibility of the lessee. The market allocation of risks can, to a certain extent, be achieved in a Sharia a compliant way by the Islamic bank appointing the lessee as its agent for the purpose of insuring the financed asset. In addition, conventional insurance is generally not considered to be Sharia a compliant on the basis that it violates the Gharar prohibition. However, if Islamic insurance (Takaful) is not available for a financed asset and that asset cannot be used without being insured to a market standard (e.g. aircraft), Islamic scholars have accepted the use of conventional insurance on the grounds of the Islamic doctrine of necessity. Luma Saqqaf, Dubai - Governing law: There are various differences between scholars relating to the interpretation of various Islamic principles. Market practice is that transaction documents are governed under a secular law rather than under Sharia a law. This is supported by the English court decision in Shamil Bank v Beximco [2003] EWHC 2008 (Comm) in which it was decided that the principles of Sharia a did not apply. One of the primary reasons for reaching its decision was the considerable difficulty in applying Sharia a to contracts. - Differences between structures in the Middle East and East Asia: Sharia a compliant financing structures adopted in the Middle East differ considerably from those adopted in East Asia. There are many reasons for these distinctions. For example, the difference in the interpretation of Sharia a between Middle Eastern scholars and Asian scholars. Middle Eastern investors tend generally to view the interpretation of Sharia a in Asia as being more lenient or liberal. Other reasons include different local laws and more importantly different tax treatments. For example, tax (such as VAT or income tax) in the Arabian Gulf countries is almost nonexistent and therefore structures are not tax driven. This is not the case in East Asia where VAT, income tax, capital gains tax, stamp duties, and other forms of taxation have a significant impact on structures. 8 June 07

9 The case of the disappearing guarantee: A real estate judgment with broader relevance? The recent High Court decision in Prudential Assurance Co Ltd and others v PRG Powerhouse Ltd and others [2007] EWHC 1002 (Ch); [2007] 19 EG 164 (CS) has caused much debate in the real estate world, focusing particularly on what could happen in a tenant s insolvency to a guarantee which a landlord was relying on. While the judgment has been considered largely in the context of landlords rights, it potentially has wider implications, which may be relevant when structuring financings in the future. This article examines those implications and some possible solutions. Relevant facts Faced with financial difficulties, PRG Powerhouse Limited ( PRG ) used a company voluntary arrangement ( CVA, see explanatory box), which was approved by a majority of its creditors, to close 35 loss-making stores whilst paying the landlords of those premises only a fraction of the (accrued and future) rental obligations. In essence, it walked away from those leases. This is, in itself, not unusual in an insolvency process, but PRG also took the additional and controversial step of including in the CVA proposal a release of the parent company guarantees which had previously been provided to landlords by PRG s parent company in respect of those leases. By doing so, PRG hoped to deal with a concern that the enforcement of those guarantees could trigger rights of subrogation, giving the guarantor a claim against PRG at a future date, as a result of the guarantor having paid out sums that PRG should itself have paid out. The affected landlords issued proceedings seeking a declaration that the CVA could not force the release of those guarantees and/or that the CVA was invalid on the basis that it was unfairly prejudicial to those holding guarantees. On 1 May 2007 the High Court found that the CVA was indeed unfairly prejudicial and consequently it was struck down. The story might have ended there, but for the fact that the judgment included an analysis which indicated that it might technically be possible to use a CVA to prevent claims being made under parent company or third party guarantees, provided that the CVA was written in such a way that it was not unfairly prejudicial. The underlying rationale for this analysis was that a CVA was effectively a statutory contract between the company and its creditors. While such a contract could not directly affect the relationship between a creditor and a third party, it could do so indirectly, where the creditor had agreed with the company as part of the CVA not to take a specific action (such as pursuing its guarantee claim against the third party). Broader application? Mr Justice Etherton acknowledged that the issue was of general importance to the commercial property market, but the case potentially goes beyond the commercial property market. It effectively confirms that, in the very situation one would look to rely on a guarantee (debtor insolvency), a CVA (or an individual voluntary arrangement or IVA in relation to individuals) may deprive creditors of future rights against third parties under guarantees and indemnities. Limiting factors to application While the judgment may cause concern, there are three significant factors limiting its potential impact in practice. First, a CVA cannot be used to affect the rights of a secured creditor to enforce its security without its agreement (section 4(3) Insolvency Act 1986). A secured creditor would therefore not normally be included in a CVA without its consent. The judgment is therefore much less of a concern in financings where, as is often the case, the creditor has taken security from the debtor as well as a parent company or third party guarantee. It is potentially much more of a concern in unsecured financings and also for suppliers and other service providers/business counterparties who don t have any security but who rely on a parent or third party guarantee. What is a CVA? A CVA is a procedure under Part I of the Insolvency Act 1986 that enables a company in financial difficulties to reach an agreement with its creditors about how its debts are to be repaid or compromised. The scheme may provide for full or partial discharge of the debts, which will be dependent upon the amount that the company can reasonably afford. CVAs cannot affect the rights of secured or preferential creditors. CVAs require the approval of over 75 percent of the voting creditors (by value) and, if approved, will bind all creditors irrespective of how or whether they voted. 9 June 07

10 Secondly, to be implemented, a CVA must be approved by over 75 per cent. by value of the voting (rather than all) creditors and by over 50 per cent. (by value) of unconnected creditors (a test which prevents a CVA proposal from being forced through using debts owed to shareholders and other group companies). A single creditor or group with sufficient interest (over 25 per cent. of the debt) can therefore block a CVA proposal, as could over 50 per cent. by value of the unconnected creditors. Though contingent or prospective creditors (those with a guarantee, indemnity or similar) and those with unliquidated claims typically have those particular rights valued on a nominal basis (usually 1), reducing their voting power, they may well also have an additional existing credit exposure which counts separately to increase their voting power. Unfortunately for the landlords in the Powerhouse case, rent arrears had not accrued for long and contingent rent claims were valued at 1, with the result that they ultimately did not have the requisite 25 per cent. to block the largest creditors (financial institutions and trading suppliers). Lastly, a CVA is not a consequence free procedure. There are probably limited circumstances in which any reasonably sized parent company guarantor would realistically be prepared to let a subsidiary enter into a CVA, given that this could trigger cross-default/crossacceleration provisions in commercial and financing contracts and could also attract adverse attention from both the press and ratings agencies. This is not to say that a bullish parent and its advisers would not attempt to use this route to avoid a guarantee liability (the Powerhouse case is not the only example of the procedure being proposed), but rather that many would think very carefully before doing so, weighing up the overall commercial implications for the group against the financial benefits of a CVA. Powerhouse confirms that a CVA...may not only rewrite the commercial agreement between a debtor and its creditors but can also deprive an unsuspecting creditor of recourse against third parties under guarantees and indemnities... Possible solutions A CVA can, as in the Powerhouse case, be challenged, but a challenge must be made within a 28-day period, and the process can be both costly and uncertain. If, at the outset of a transaction, it is felt that a parent or third party might attempt to avoid their guarantee liability by allowing a borrower to go into a CVA, despite the considerations outlined above, there may be ways to structure around the issue. Obviously, particular transaction requirements will determine which, if any, of the following suggestions may be appropriate and, as a general comment, there will be limited circumstances in which a lender would be prepared to provide funding to an obligor group where it was felt that there was a real risk of the borrower being forced by financial difficulties into a CVA. - Structuring: As long as you are owed more than 25 per cent. of the company s debt, there should be no risk of a CVA being passed without your approval. One option would therefore be to remove, or at least reduce, the risk of there being other third party creditors whose claims could be used to outvote your claim in a CVA by using a SPV structure supported by various contractual undertakings to limit the SPV s credit exposure. Though not appropriate in all financing arrangements, this could be a workable solution in a real estate context where leases could be held in a separate company from the trading company, thus reducing the landlords exposure to other creditors. The downside of the weaker credit status of a SPV should largely be offset by the fact that you would also be relying on a parent company or third party guarantee to support the SPV s credit. - Security: An easier solution for general financial creditors might be to require security (even a mere floating charge) as a condition precedent to provision of facilities. As previously noted, secured creditors are typically not included in any CVA proposal, since to the extent that a CVA affects a secured creditor s rights to enforce their security, an unwilling secured creditor will fall outside the scope of the CVA. - Waiver of rights by the guarantor: Given that the main justification for asking for parent company and third party guarantees to be released as part of a CVA would be to avoid the consequences of rights of subrogation arising, a guarantee could provide for a waiver of (or undertaking not to exercise) the guarantor s rights of subrogation in a CVA of the debtor. 10 June 07

11 - Bilateral contract between the guarantor and the creditor: A more highly engineered solution would be to create a separate bilateral contract between the guarantor and creditor. For example, in cases where lease obligations are guaranteed, the guarantee could be coupled with a separate put option, allowing the landlord to put its property interest onto the guarantor, should it wish to do so, the put price being linked to the guarantee liability. In other cases there could simply be an independent primary obligation to pay the creditor should certain CVA-linked trigger conditions arise. The form of arrangement would depend on the particular transaction and would have to be carefully drafted to expressly exclude any implied rights of surety or contribution between the guarantor and debtor, but an arrangement of this nature could be considered where other options were not felt to be viable. Other solutions will of course exist, but care needs to be taken to avoid arrangements which themselves could ultimately be compromised as part of a CVA. Conclusion Powerhouse confirms that a CVA (or IVA) may not only rewrite the commercial agreement between a debtor and its creditors but can also deprive an unsuspecting creditor of recourse against third parties under guarantees and indemnities. While this appears at first glance to pose a significant threat, there are legal and commercial factors which will restrict the use of a CVA (or IVA) in practice and, ultimately, there are possible mitigating steps that a concerned creditor could consider at the beginning of a transaction to potentially further reduce the risks of a guarantee or indemnity obligation being released through a CVA (or IVA). Jo Windsor, London 11 June 07

12 Overview of acquisition finance structures in India India is becoming an increasingly desirable destination for capital and financial sponsors and lenders alike are exploring ways of financing acquisitions in India on a leveraged basis. There are four key obstacles to achieving a traditional leveraged acquisition financing structure in India: - strict regulation by India s central bank, the Reserve Bank of India ( RBI ), of foreign currency borrowings by Indian entities, by means of guidelines on External Commercial Borrowings, known as the ECB Guidelines ; - difficulties in acquiring minority shareholders interests, given the absence of compulsory acquisition or squeeze-out procedures in India; - issues relating to creation and enforcement of security over real estate in India and shares in Indian companies, in light of the need for prior RBI approval; and - the prohibition on financial assistance. This article highlights these key difficulties in achieving a traditional leveraged acquisition financing structure in India and explores some of the arrangements that are emerging in order to meet the commercial objectives of the parties. Structuring solutions... are now offering some opportunity to complete Indian acquisition financings on a basis consistent with lenders credit support requirements. Hurdles to traditional leveraged acquisition financing External Commercial Borrowings or ECBs The ECB Guidelines are not conducive to acquisition finance activity in India. Put simply, the ECB Guidelines restrict utilisation of ECBs to the acquisition of shares in government-owned companies only, and exclude their use in acquiring shares of all other companies. What are ECBs and when do the ECB Guidelines apply? The term External Commercial Borrowing or ECB is used to refer to commercial loans in the form of bank loans, buyers credit, suppliers credit and securitised instruments made available to Indian entities by nonresident lenders. This method of raising money by Indian companies has been popular in the past few years as a result of the high differential between Indian interest rates and those of other currencies. The ECB Guidelines are relevant in the context of Indian borrowers who wish to borrow for the purposes of domestic private acquisitions, as well as for any cross-border acquisitions where any offshore debt is to be incurred at the Indian target level post-acquisition. This means that it is difficult for Indian companies to receive loans or credit from non-indian lenders in the context of a private acquisition. Where the ECB Guidelines apply, Indian companies may only access ECBs in accordance with the requirements of the ECB Guidelines. ECBs can be accessed via one of two routes, the Automatic Route or the Approval Route. This article focuses on the Automatic Route. Set out below are a number of other restrictions to be borne in mind when seeking to access ECBs under the Automatic Route. - Term and amount: To qualify for the Automatic Route, the loan must be for a minimum average maturity of 3 years (if less than US$20 million) or 5 years (if between US$20 million and US$500 million). A borrower can raise a maximum of US$500 million in any single financial year under the Automatic Route. - Recognised lenders: Only certain categories of internationally recognised sources are permitted to extend ECBs including: (i) international banks, (ii) international capital markets, (iii) multilateral agencies (such as International Finance Corporation, the Asian Development Bank, etc.), (iv) export credit agencies, (v) foreign collaborators, (i.e. foreign parties who collaborate on technology matters with an Indian company borrower), and (vi) a foreign equity holder who holds more than 25 per cent. equity interest in the borrower. This excludes hedge and other funds and possibly lending subsidiaries of investment banks. - All-in-cost ceiling: The all-in-cost of an ECB is capped at 6 month LIBOR basis points (for loans with average maturity of more than 5 years) and 6 month LIBOR basis points (for loans with average maturity of between 3 and 5 years). All-in-cost includes interest, other fees and expenses payable in forex but excludes fees payable in Indian 12 June 07

13 Rupees and withholding tax paid in Indian Rupees. This pricing may be viewed as challenging in the context of mezzanine or junior acquisition funding. - End-use restrictions: The ECB Guidelines specify certain end-use restrictions in respect of any ECBs raised including capital expenditure (primarily, in the industrial and infrastructure sector), direct investment in joint ventures, share acquisitions under the government s disinvestment programme and refinancing of existing ECBs on certain conditions. ECBs cannot be used for share acquisitions other than under the government s disinvestment programme, nor can they be used for on-lending, working capital, general corporate purposes or for refinancing existing Rupee loans. - Voluntary and mandatory prepayments: An Indian borrower is only permitted to prepay a maximum of US$400 million of each foreign loan (subject to compliance with overall average maturity requirements referred to above), without the approval of the RBI. The mandatory prepayment triggers such as for change in control, fund raisings, IPOs or cash sweeps in typical leveraged facility agreements would therefore likely require RBI approval before the borrower is able to make such prepayments. Minority shareholders in public acquisitions The lack of a formal compulsory acquisition or squeeze-out procedure in India leaves acquirers at risk of having to deal with a recalcitrant minority. It is very difficult to squeeze-out minority shareholders in India. Squeeze-outs are generally effected by a two step process to get to a 100 per cent. shareholding. The first step is for the acquirer to make a delisting offer. This is then coupled with a reduction of capital or scheme of arrangement, both of which require approval of shareholders by a 3/4 majority coupled with the High Court s approval. In each case, these processes could take at least 3 to 4 months and are not guaranteed to result in a 100 per cent. shareholding. This leaves lenders facing the risk of leakage in the event of dividend payments to the minority shareholders. Financial assistance The financial assistance prohibition may be an issue on some transactions, such as public takeovers. The Indian Companies Act prohibits any public company or any private company that is a subsidiary of a public company from giving financial assistance, including any upstream guarantee or security, for the acquisition of its shares or those of its parent (whether incorporated in India or not). This prohibition does not apply to private companies other than as stated above. There are no exceptions to this prohibition and no whitewash procedure. Security Security may be problematic for two reasons. First, a charge or mortgage over immovable property such as land or shares in India created in favour of a foreign bank (or any foreign entity) can only be created with the prior approval of the RBI. Secondly, such a charge or mortgage cannot be created directly in favour of a foreign entity. This issue is typically addressed by creating security in favour of an Indian entity appointed by the foreign lenders and the Indian entity then holds the charge for the benefit of the foreign lenders. The charge may then be enforced by this Indian entity, but further approval of the RBI would be required to repatriate the proceeds outside India of any sale of the immovable assets or shares upon any such enforcement. Emerging arrangements Considered below are some of the arrangements emerging in the Indian market to structure around the hurdles referred to above. Preference share financing Preference shares without conversion features have been popular as investment products in Indian companies with foreign investment restrictions, since they were exempt from foreign investment sectoral caps and were not treated as ECBs. There is now some uncertainty in the market as to whether the popularity of preference share financing will continue, following the issue by the Government on 30 April 2007 of new guidelines which change the foreign investment policy in respect of preference shares. Under the new guidelines, foreign investment in non-convertible, optionally convertible or partially convertible preference shares is to be treated as debt and needs to comply with the ECB Guidelines. Promoter and/or acquisition financing Under this structure, an offshore subsidiary owned by a promoter Indian company which is engaged in bona fide business activities abroad can raise debt from an offshore lender. The generally accepted view is that borrowing money and on-lending it or investing it in India should be sufficient for the offshore subsidiary to be deemed to be engaged in a bona fide business. Any loans lent by an offshore lender to the offshore subsidiary will not be governed by the ECB Guidelines. 13 June 07

14 The offshore vehicle can subscribe for, or acquire, the equity of any Indian company with these funds, in compliance with the Indian overseas direct investment guidelines or ( ODI ) guidelines. The Indian promoter or any of its Indian subsidiaries can guarantee the loan to its offshore subsidiary, following recent relaxations in the ODI guidelines, subject to a cap. This structure therefore permits an Indian promoter to access cross-border finance offshore for equity investment in India and allows for leveraged acquisition financing of Indian companies. Philip Badge and Narayan Iyer, Singapore Post-acquisition, the offshore borrower may merge with the Indian target (thus allowing the offshore lenders to get closer to the operating assets). However, mergers between Indian entities and offshore entities are rare and can take up to a year. Different views exist as to whether the borrowing at the offshore borrower level will need to comply with the ECB Guidelines post-merger. Asset acquisition An offshore lender may lend directly to an Indian borrower to purchase assets in compliance with the ECB Guidelines. Asset acquisitions are in the nature of capital expenditure and are an expressly permitted end use for ECBs. The lender may obtain credit support in the form of (i) an indemnity from an offshore subsidiary for losses and/or additional cost categories in relation to the facility (subject to corporate benefit requirements and the requirement that the offshore subsidiary must be engaged in bona fide business activity (discussed in more detail above)), or (ii) a guarantee from the Indian company of the obligations of the offshore subsidiary pursuant to the ODI guidelines (again, subject to the requirement that the offshore subsidiary must be engaged in a bona fide business activity). Conclusion Structuring solutions such as those set out above are now offering some opportunity to complete Indian acquisition financings on a basis consistent with lenders credit support requirements and yield requirements enjoyed by investors in other jurisdictions. It remains to be seen to what extent there will be further development of financing structures to facilitate the use of traditional leveraged financing techniques and related pricing for Indian domestic acquisitions. 14 June 07

15 Are your endeavours good enough? Introduction In many commercial contracts, including loan agreements, one or both parties will be unwilling to give an absolute commitment to a particular objective as it may be unclear how onerous it will be in practice or because it is dependent on matters beyond their control. In such cases, it is common for parties to instead agree to include an obligation to use best endeavours or reasonable endeavours or all reasonable endeavours to achieve the relevant objective or result. While the assumption made by most parties when negotiating the inclusion of these words is that a reasonable endeavours obligation is far less onerous in practice than a best endeavours obligation, there is often uncertainty about the precise meaning of those words and what steps a party must take to avoid breaching them. Two recent cases have however, highlighted the distinction between these types of endeavours obligations and given some helpful guidance on their characteristics. While a best endeavours obligation does not require a party to take steps which are unreasonable, a party subject to such obligation needs to attempt all options to achieve the desired outcome, rather than just one. Best v reasonable endeavours In the case of Rhodia International Holding Limited v Huntsman International LLC [2007] EWHC 292, a dispute arose out of an agreement by Rhodia to sell its chemical business to Huntsman. Huntsman and Rhodia were under an obligation in the 2001 sale agreement to use reasonable endeavours to obtain third party consents necessary to transfer certain agreements. Huntsman was also under an obligation to provide a parent company guarantee if requested by a third party. By 2004, one particular agreement still had not been transferred mainly because Huntsman refused to provide a parent company guarantee. Rhodia claimed that Huntsman had breached its reasonable endeavours obligation. The High Court considered whether there was a meaningful difference between the phrases best endeavours and reasonable endeavours. The judge clarified that the phrases are not the same and that as a matter of language and business common-sense, untrammelled by authority, the reasonable endeavours obligation was a less stringent obligation than best endeavours. The crucial difference between the two is that an obligation to use reasonable endeavours probably only requires a party to take one reasonable course he can, not all of the available or possible courses of action, while a best endeavours obligation requires a party to take all reasonable courses of action. So while a best endeavours obligation does not require a party to take steps which are unreasonable, a party subject to such obligation needs to attempt all options to achieve the desired outcome, rather than just one or a few. Helpfully, the judge also pointed out that where a party is using reasonable endeavours towards the relevant end, it is not required to sacrifice its own commercial interest. However, if the contract actually specifies certain steps which have to be taken as part of the exercise, those steps will have to be taken even if that could be said to be including the sacrificing of a party s own commercial interest. This case reaffirms that a party subject to an obligation to use reasonable endeavours is entitled to put his own commercial interests in the forefront, whereas a party subject to a best endeavours obligation must put the other party s interests at the forefront, although it is not required to completely disregard its own commercial interests. All reasonable endeavours While it is more common for parties to choose either a reasonable endeavours or best endeavours obligation, some contracts contain an obligation to use all reasonable endeavours. In the case of Yewbelle v London Green, a property sale agreement between Yewbelle and London Green Developments was conditional on obtaining a planning agreement with Merton London Borough. Yewbelle agreed to use all reasonable endeavours to obtain final planning agreement. However, Yewbelle discovered that in order to obtain a final agreement it would have needed either to purchase the land or make the owner a party which would have required substantial payments. 15 June 07

16 The Court of Appeal agreed that while the all reasonable endeavours obligation required Yewbelle to continue to use its endeavours until the point is reached when all reasonable endeavours have been exhausted, it was not reasonable for Yewbelle to incur significant expenditure to fulfil the obligation. This is a sensible decision as it illustrates that while a company may have to incur some expenditure in taking action to fulfil its obligation it is not required to incur a significant or unreasonable level of expenditure or take action which is commercially impracticable. Practical points These decisions, while fact sensitive, have highlighted some of the characteristics of different types of endeavours clauses. However, it is clear from these cases that what an endeavours clause will require in any particular case depends on the other provisions of the agreement, as well as the surrounding commercial context. Uncertainty as to the exact level of effort required remains in any given case. Therefore, when including a particular type of endeavours clause in an agreement it is worthwhile considering whether to include steps a party should take in the context of that particular obligation to achieve greater certainty as to the requirements of the term. As shown in the Rhodia case, the specific requirement to provide a parent guarantee was determinative. The specific steps will vary from case to case but regard should be had to issues such as the period of time during which the party should pursue that objective, whether it should have to bear any costs or make any expenditure and specific activities it is not expected to carry out. Allegra Miles, London 16 June 07

17 Update on developments in UK withholding tax provisions and treaty lenders in syndicated loans In the December 2006 issue of Banking Update, we reported on concerns in the syndicated loan market in relation to the risk of delay in HM Revenue & Customs ( HMRC ) processing applications under a double tax treaty to pay interest to non-resident lenders gross or subject to a reduced rate of withholding tax. In response to those concerns, HMRC has recently published details of their new procedure for dealing with such applications which is intended to expedite the clearance process. HMRC has also extended the circumstances in which a taxpayer can enter into thin capitalisation agreements. These developments are considered in more detail below. Treaty clearance procedure As discussed in the December 2006 issue, recent experience suggests that the process of obtaining a treaty clearance can take four to six months. In an effort to reduce turn-around times, HMRC will now no longer consider the arm s length nature of the loan as part of the clearance process. Provided, therefore, that the application meets the other criteria set out in the relevant treaty, a direction to pay gross or subject to withholding at the treaty rate will be issued by HMRC. The borrower s local tax office will be notified of the decision to issue a clearance and will then review the arrangements from an arm s length perspective as part of the general review of the borrower s self assessment returns. This new procedure will be applied in respect of treaty applications which are received by HMRC after 21 March 2007, having been certified by the tax authorities in the lender s jurisdiction. Certified applications already received by HMRC on or before that date will continue to be dealt with under the old procedure. It is not yet clear how much of an impact this will have on the time taken to process applications for treaty clearance. The Provisional Treaty Relief Scheme, which is specifically designed to address the delay in the treaty clearance process but until recently was not often used in practice, will continue to be available in most cases. It may be a better solution where a short first interest period is unavoidable, since it currently takes about five days to get a provisional direction under the scheme. In an effort to reduce turn-around times, HMRC will now no longer consider the arm s length nature of a loan as part of the clearance process...in respect of treaty applications received by HMRC after 21 March Thin capitalisation agreements Previously, a UK borrower could enter into a thin capitalisation agreement with HMRC only as part of an application for treaty relief from an overseas lender. With a view to increasing certainty for borrowers as to the debt/equity level that HMRC considers is supportable on an arm s length basis, the circumstances in which a taxpayer can negotiate a thin capitalisation agreement have been extended. It will now be possible for a UK borrower to request an agreement where no withholding tax arises because, for example, one of the domestic exemptions applies. The existing advanced pricing agreement ( APA ) legislation in the Finance Act 1999 will be applied in relation to the new agreements, which are likely to last between three and five years depending on the individual circumstances of the borrower. A draft Statement of Practice which provides guidance on how HMRC intends to apply that legislation to thin capitalisation cases has been published for comments and can be viewed at The Statement of Practice sets out particular situations that HMRC considers would be suitable for an advance thin capitalisation agreement as follows: - intra-group funding where a treaty clearance is not required to avoid an obligation to withhold tax; - debt which is brought within the transfer pricing rules pursuant to the broad provisions which apply where persons are acting together in relation to financing arrangements; and 17 June 07

18 - financing between UK resident entities where the interest payable has a material impact on the profits of the borrower. However, it advises that HMRC is unlikely to accept an application where any impact on the borrower s taxable profits would be eliminated through compensating adjustments, e.g. funding within a UK resident group. Applications relating to less complicated matters may also be declined on the basis of resource constraints. Stephen Taylor and Alexandra Costa-D sa, London 18 June 07

19 Recent US netting legislation marks further expansion of protections for non-debtor counterparties to financial contracts in bankruptcy On 12 December 2006, President Bush signed the Financial Netting Improvements Act of 2006 (the Act ) into law. The Act is intended to improve the netting process for financial contracts. The Act marks the continuation of a trend towards expanding the protections available for financial contracts so as to minimise the impact of counterparty bankruptcies on the financial markets, building upon the significant expansion of financial contract protections implemented by the Bankruptcy Abuse Prevention and Consumer Protection Act of The Act amends certain provisions of the United States Bankruptcy Code in order to expand the protections available to non-bankrupt counterparties to certain types of financial contracts, such as swap agreements, repurchase agreements and securities contracts. In summary, the Act: - places additional financial products within the definitions of the financial contracts which are eligible for special protections under the Bankruptcy Code; - broadens the scope of the exceptions to the Bankruptcy Code s automatic stay (the Automatic Stay ) which are available for certain financial contracts; and - expands the scope of the Bankruptcy Code s protections from avoidance of certain pre-bankruptcy payments made in connection with protected financial contracts. Bankruptcy Code: Financial contract protections generally Absent an exception, the Automatic Stay operates to stay substantially all creditor enforcement action, including the termination, liquidation or acceleration of rights under contracts with a debtor and the exercise of rights against collateral securing obligations of the debtor under those contracts. Further, the Bankruptcy Code generally prohibits a non-debtor counterparty from terminating, liquidating or accelerating a contract on account of a bankruptcy or insolvency-related default. Pre-bankruptcy payments made by debtors under contracts are generally subject to avoidance in bankruptcy if they qualify as preferential transfers or fraudulent transfers. The financial contract protections under the Bankruptcy Code operate to (i) permit the exercise of rights under protected financial contracts upon a counterparty insolvency, notwithstanding the Automatic Stay and the Bankruptcy Code s prohibition of the enforcement of bankruptcy default clauses, and (ii) exempt certain pre-bankruptcy transfers made in connection with protected financial contracts from avoidance as preferential transfers or fraudulent transfers. Expansion of the financial contracts eligible for protection under the Bankruptcy Code An important part of the Act is its expansion of the definition of the types of contracts eligible for the Bankruptcy Code s special financial contract protections: - Swap agreement now expressly includes emissions and inflation, swap, option, future or forward agreement[s], and in addition also includes a catch-all for other commodity agreement[s]. - Securities contract now expressly includes any extension of credit for the clearance or settlement of securities transactions, any loan transaction coupled with a securities collar transaction, any prepaid forward securities transaction, or any total return swap transaction coupled with a securities sale transaction. Expansion of exemptions from the Automatic Stay The Automatic Stay exemptions in: - Section 362(b)(6) (applicable to securities contracts, forward contracts, and commodity contracts ); - Section 362(b)(7) (applicable to repurchase agreements ); - Section 362(b)(17) (applicable to swap agreements ); and - Section 362(b)(27) (applicable to master netting agreements ), have been amended to exempt the exercise of any contractual right (i.e. a right under the express terms of a protected financial contract or a right set forth in a rule or bylaw of various enumerated agencies, clearing organisations and exchanges) (i) under any security agreement or arrangement or other credit enhancement forming part of, or related to a protected financial contract or (ii) arising under or 19 June 07

20 in connection with a protected financial contract to offset or net out any termination value, payment amount, or other transfer obligation. Under prior law, the exemption from the Automatic Stay applicable to protected financial contracts was limited to the setoff of a mutual debt and claim and, in the case of the exercise of rights under or in connection with securities contracts, repurchase agreements, forward contracts, or commodities contracts required that the set-off be in respect of a claim against the debtor for a margin payment or a settlement payment. On their face, the exemptions from Automatic Stay with respect to protected financial contracts have been broadened considerably. However, it remains to be seen how bankruptcy courts will construe these exemptions in light of their amendment by the Act. If construed literally, the exemptions now appear to permit the exercise of any contractually based enforcement rights against collateral or other forms of credit enhancement provided as security in connection with a protected financial contract, without requiring that (i) any contractual netting be subject to a requirement of mutuality or (ii) such netting be in respect of a claim for a margin payment or settlement payment. The elimination from the statutory language of the requirement that the exercise of rights constitute a set-off in respect of a claim for a settlement payment is potentially significant, given that some bankruptcy courts had previously construed the term settlement payment to apply only to payments made in connection with transactions affecting the public securities markets, as opposed to purely private transactions. Expansion of anti-avoidance exemptions a settlement payment. The new law now eliminates the requirement that a payment must constitute a margin payment or settlement payment. This is potentially significant given that, as noted above, some courts in the past have construed the term settlement payment to apply only to payments made in connection with transactions affecting the public securities markets, as opposed to purely private transactions. Again, it will be interesting to see how the bankruptcy courts will construe the expanded exemptions in practice. Joel Moss, New York...the exemptions from the Automatic Stay with respect to protected financial contracts have been broadened considerably. However, it remains to be seen how bankruptcy courts will construe these. The Bankruptcy Code exempts certain pre-bankruptcy payments made in connection with protected financial contracts from avoidance as preferences or fraudulent transfers (other than those transfers made with the intent to hinder, delay or defraud creditors), so long as the payment is made by, to or for the benefit of, a protected party such as a financial institution, financial participant, repo participant, swap participant, or stockbroker and is a payment made in connection with a protected financial contract. Under prior law, the exemption was generally only available if the above conditions were satisfied and the payment constituted a margin payment or 20 June 07

21 Cross-border financing: Taking security in Portugal In the context of cross-border acquisition financings, Portuguese target companies and their subsidiaries are often required to provide credit support for liabilities owed to lenders under the finance documents. This article summarises the key issues to consider when taking security from Portuguese companies, including the prohibition on financial assistance and the potential liability to Portuguese stamp duty. Security: An overview Under Portuguese law there is no concept of a floating charge, and therefore lenders may not obtain the benefit of general asset security over all or substantially all of the assets of a Portuguese company. The closest in form to a floating charge is: - a pledge over an ongoing business (penhor de estabelecimento comercial), which can be used to secure the assets and rights owned by a company and used in the course of its business, including the leases of the premises where business is carried out (but not other real estate assets, which must be secured by mortgage), some fixed assets (such as machinery and stock), intellectual property rights, receivables and contractual rights; and - a mortgage over plant and machinery (hipoteca de fábrica), which can be used to secure the property where the plant is established, the machinery and identified movable assets (such as equipment and tools). Where security over identified assets of a Portuguese company is granted, separate pledges are required over separate classes of assets, which typically must be governed by Portuguese law. There is no general companies security register at which security interests created by Portuguese companies must be registered. However, specific requirements apply in order to perfect security interests over some types of assets. For instance, security over real estate must be executed by public deed before a Portuguese notary and filed with the Real Estate Registry. A pledge over quotas in sociedades por quotas, a Portuguese limited liability company, must be filed with the relevant Companies Registry. Portuguese law does not distinguish legal ownership and beneficial ownership. Consequently, there is no concept equivalent to the common law trust. Likewise, the concept of parallel debt is not accepted under Portuguese law. However, it is possible to have a security agent acting on behalf of the Lenders, if the security agent has been duly empowered to act on their behalf as their attorney. Financial assistance Portuguese law prohibits a Portuguese company from providing financial assistance in connection with the acquisition of its share or those of its parent subject to limited exceptions...there is no whitewash procedure... as under English law Portuguese law prohibits a Portuguese company from providing financial assistance in connection with the acquisition of its shares or those of its parent, subject to limited exceptions. The prohibition applies to guarantees, loans, security or any other form of financial assistance given in order to enable a third party to acquire shares representing its issued share capital. There is no whitewash procedure under Portuguese law, as under English law. Penalties for breach of the prohibition include the transaction being null and void and criminal liability for directors. In an acquisition financing, a Portuguese target and its Portuguese subsidiaries will therefore typically not be able to provide security or guarantees in relation to loans to finance the acquisition. Market practice is to limit the obligations guaranteed or secured by a Portuguese company only to other loans, such as those made available to finance general corporate purposes and/or working capital requirements. Stamp duty When taking security from a Portuguese company, stamp duty is payable on the secured amount where the security is (i) granted or executed within Portugal or (ii) granted abroad and either the beneficiary of the security is a Portuguese taxpayer or the security 21 June 07

22 is enforced in Portugal or is presented in Portugal in legal proceedings or before any official body unless, in each case, the security is collateral to a facility agreement which is itself subject to stamp duty and the security is granted at the same time as that agreement (thus avoiding a dual tax charge). Stamp duty is payable on the amount secured and the rate depends on the duration of the secured obligations. The applicable rates are: 0.04 per cent. per month or part thereof for security with a term of less than one year; 0.5 per cent. for security with a term of one year or ranging between one year and up to five years; and 0.6 per cent. for security with a term of five years or more. This can lead to significant costs, particularly in the context of all monies security. Pedro Siza Vieira and Marta Afonso, Lisbon It may be possible to structure transactions in order to minimise the impact of stamp duty. Structuring solutions that may be considered include (i) utilising any applicable tax exemptions (e.g. the exemption for transactions between financial institutions), (ii) reducing the secured amount or (iii) structuring the transaction so that security is not subject to Portuguese stamp duty, provided that the structure is chosen on the basis of sound economic and business reasons. For example, in the context of security over shares held in a centralised system such as Clearstream or Euroclear, or registered/deposited with a financial intermediary overseas, the Portuguese Securities Code sets out that the law governing the security will depend on where the management entity of the centralised system or the financial intermediary (as the case may be) is located. If the shares are deposited or registered outside Portuguese territory and as long as the execution of the security agreement and the acts required for the perfection of security are performed outside Portuguese territory, the prevailing view is that stamp duty will not be due at the time the security is granted (but would be due if the security were to be enforced in Portugal). Conclusion Taking security under Portuguese law is, to some extent, similar to taking security in other continental jurisdictions. When structuring transactions involving the granting of security by a Portuguese company, it is important to be aware of the limitations imposed by the prohibition on financial assistance and the potential liability to stamp duty. 22 June 07