December 2004 1

Second lien financings and the European loan markets

Second lien financings are unquestionably one of the hottest topics in the European loan markets. They are an asset class that has recently boomed in the US; Standard & Poor�s reports second lien volumes in the US of $3.3 billion in 2003 exploding to $9.9 billion in the first three-quarters of 2004 and notes that second liens are the fastest growing segment of the leveraged loan market. Given this growth it is unsurprising that, like high yield bonds before them, financial institutions have sought to export this product to Europe.

What is a second lien financing?

A second lien financing is a financing which is secured on a second ranking basis by (more or less) the same security package which secures the first ranking financing. The first lien lenders and the second lien lenders agree that, in the event of a security enforcement, the first lien lenders will be paid in full from the security realisation proceeds before the second lien lenders receive any realisation proceeds. In the US market this ranking of security is referred to as �lien subordination�.

Importantly, second lien financings are not normally contractually subordinated (�payment subordination�) to the first lien financing in the way that mezzanine financings and high yield bonds are. This lack of payment subordination is the principal structural difference between a second lien financing and a mezzanine financing or a high yield issue. Some of the initial European deals featured payment subordination as well as �lien subordination�, making them look more like senior mezzanine financings. However, this would not work in the US market and none of the more recent European deals have featured payment subordination.

Why are second liens popular?

Second liens are popular because they provide borrowers, particularly financial sponsors, with the ability to further stretch capital structures.

Banking Update.

Contents

Second lien financings and the European loan markets 1 The new Spanish Insolvency Act: practical issues 5 The consequences of wrongful acceleration 9 Power to mortgage under Belgian law 12 Financial Collateral Act in Poland 14 Basel II and impact on loan documentation 16 New Private International Law Code in Belgium 22 How new tax disclosure rules affect lending transactions 23 Public private partnerships in France 26

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Second lien financings appeal to a wider body of investors than traditional mezzanine or high yield products. For example, hedge funds which cannot invest in contractually subordinated debt can invest in second lien debt as it counts as senior debt due to the absence of payment subordination.

Additionally, such financings can be readily structured as both loans and public notes. Second lien deals also allow borrowers to raise debt more cheaply than from mezzanine or high yield products. They do not carry warrants (and so do not dilute equity return) and the pricing is typically in the range of 4.5 to 6.5% per annum over LIBOR.

The silence of the second liens

Second lien security is often described as being �silent� or �quiet�. What this means is that the second lien lenders give up many of their rights in relation to the security package so that the first lien lenders control the security package. This often includes a waiver by the second lien lenders of any right to challenge the first lien lenders� security, a waiver of the second lien lenders� rights to enforce their security except in very limited circumstances and a requirement for the second lien lenders to release their security where such release is required as part of a security enforcement by the first lien lenders.

The number of restrictions placed on the second lien lenders and their security will determine just how �quiet� the second lien security is and this is usually the major negotiation point between the first and second lien lenders. In general, second lien note issues will be �quieter� than second lien bank loans.

Structuring issues for second lien loans

As in the past with high yield bonds, financial institutions are having to mould the US second lien concept to the very different market conditions and legal frameworks found in Europe. The structuring of second lien loans in the US is generated largely by features of the US bankruptcy regime, which include post-bankruptcy petition interest rights, rights in relation to �debtor-in-possession� financings and rights of secured lenders to be protected against declines in the value of his security. Because bankruptcy regimes in Europe are diverse and generally very different from that in the US, US structures are often of only limited applicability and relevance to European situations.

Some of the key structuring issues are considered below:

• Cross default/cross acceleration - It is not uncommon for second lien deals to have cross acceleration instead of cross default. In the US, where cross default rights are granted it is not uncommon for those rights to become effective only after a delay period (e.g. 45-90 days).

Bruce Bell

Banking Update. 3

• Mandatory prepayment - Second liens will usually feature the same mandatory prepayment events as a first lien financing but those prepayments will only need to be made to the extent that the relevant proceeds are not required to be applied in prepayment of the first lien debt.

• �No call� periods and prepayment premia - There are often restrictions on the ability to voluntarily prepay a second lien financing (e.g. no prepayments in the first one or two years) and prepayment premia are common, often on similar terms to those one would see on a mezzanine financing.

• Payment blocks - Most European second lien deals have featured an ability for the first lien lenders to stop payments being made on the second lien debt if an event of default occurs. This is in marked contrast to the US where payment blocks are rare. There is little consensus on how long these blockage periods should last and they range from as little as 90 days to as long as 179 days (and in some exceptional cases are indefinite, lasting until the relevant event of default is cured or waived).

• Covenant packages � A second lien covenant package is often lighter than the package in the first lien financing. Some deals have featured high yield-style �incurrence� covenants rather than senior bank �maintenance� covenants; other deals have featured first lien covenants but with greater headroom built into each covenant. Financial covenants will usually be less restrictive than those in the first lien financing and are often ratcheted back in a similar way to mezzanine deals.

• Enforcement standstills - European second lien deals typically feature a standstill period after a second lien event of default during which the second lien lenders are prohibited from taking any enforcement action. These standstill periods often look very much like mezzanine standstill periods (e.g. 90 days for a payment default, 120 days for a financial covenant default and 150 days for any other default).

Are second lien loans here to stay?

A question many in Europe are asking is whether second liens are a passing fad or a product which will become a permanent feature of the European debt markets. Standard & Poor�s has noted that, despite the generally rising volume of second lien deals in the US, this volume has slipped in recent months and queried whether second liens are �a bear-market product that may go into semi-hibernation when the credit markets strengthen�. Standard & Poor�s has also questioned whether second lien lenders� recovery

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expectations from their second ranking security are over-optimistic and whether such loans should really be thought of as �senior debt� at all given the number of rights that second lien lenders usually waive, in doing so commenting that:

��for all practical purposes, second-lien lenders have neither the ability to assert rights as senior secured lenders (save for those actions taken by the first-lien lenders) nor the ability to assert rights as unsecured lenders. As a result, the recovery prospects for the second-lien bank debts rated by Standard & Poor's are in no practical way enhanced by the instruments' legal structure, and the underlying collateral coverage for a vast amount of second-lien structures provides only very limited recovery prospects.�

The future of the second lien phenomenon in the US is therefore unclear. It remains to be seen whether the same concerns will apply to the European second lien market and to what extent uncertainty in the US will affect the growth of this market. In the meantime, the increase in second lien deals in the European market may lead to the consistency and standardisation that is being achieved on mezzanine and, more recently, high yield products.

Bruce Bell

London

Banking Update. 5

The new Spanish Insolvency Act: practical issues

On 1 September 2004 the new Spanish Insolvency Act (Ley Concursal) (the �Act�) came into force.

This update sets out some of the practical matters arising on banking transactions as a result of the implementation of the Act, as well as highlighting certain measures that can be taken by lenders to mitigate the impact of the Act on enforcement of credit facilities, security and priority.

Security

Enforcement of Security

In order to facilitate the continuation of the insolvent debtor�s business, the Act provides that the enforcement of security over those assets necessary for its business may not be initiated until the earlier of (i) the date a creditor�s agreement is reached or (ii) one year from the declaration of insolvency (where the insolvent debtor�s assets have not already been liquidated). Any ongoing enforcement proceedings will also be suspended from the date of declaration of the debtor�s insolvency for the same period.

In order to mitigate the impact of this compulsory delay in enforcement, the following measures should be considered by lenders when taking security over the assets of a Spanish borrower:

• obtain a guarantee from a third party in addition to or instead of the security;

• secure obligations by taking security over assets located within the EU but outside Spain since the European Insolvency Regulations (Regulation No. 1346/2000) provide that enforcement over non-Spanish assets may not be prevented (whether or not those assets are necessary for the business of the insolvent debtor).

New security on pre-existing debt

The Act introduces a presumption that the granting by the debtor of new security in respect of pre-existing debt is detrimental to other creditors and, as a result, may be challenged. This presumption affects any security granted in the two years prior to the declaration of insolvency, and will apply even in cases where the creditor benefiting from the security did not intend to prejudice the insolvent estate or other creditors. This presumption is rebuttable.

The administrators of the insolvent estate (and/or other creditors where the administrators have failed to lodge a challenge within 2 months of a request to do so from such creditors) can make a challenge. Should the challenge of the new security be successful, it will be declared null and void.

Andrés Lorrio

Guillermo Yuste

December 2004 6

Reclassification of credits

The Act provides that secured credit rights are entitled to a preferred ranking (i.e. they are specially privileged credit rights). Personal guarantees however are not entitled to any preferred status. Where a creditor benefits from both a security interest and a guarantee in respect of obligations owed to it by the debtor, the Act appears to imply that, when classifying such credit right for payment purposes, the administrators may elect to satisfy the obligations of the debtor in the manner which would have the least impact on the debtor�s estate (i.e. it may be possible for the administrators to ignore the existence of security securing any credit right that also benefits at the same time from a guarantee).

The scope of this provision is not clear and it remains uncertain whether this provision applies to the original creditor (with a risk of such creditor�s protection being downgraded where it holds the benefit of more than one security interest/guarantee) or only to the credit that would arise in favour of the guarantor against the debtor once any payment under the guarantee has been made to the original creditor (under Spanish law, the guarantor would have action against the debtor by way of indemnity or, alternatively, by subrogation of the original creditor).

The better view is that this rule only affects the guarantor, although until established case law is created, it is difficult to be definitive on this point.

Ranking of Debt/Subordination

The Act has substantially altered credit ranking rules with a view to reducing and clarifying the credits that are privileged or preferred. Under the Act, the most common way to obtain priority in ranking is to take security.

Notarised debt is no longer preferred to the company�s ordinary creditors. The priority given to notarised debt led to the practice in Spain of raising an unsecured loan agreement to a �public document�. However, the removal of the priority of notarised debt should not affect this practice, as notarial debt has other important advantages under Spanish law, such as the ability to commence summary proceedings for repayment of the debt.

The Act has also recognised for the first time a new category of �subordinated credits� that will rank below ordinary creditors. Until now, the only subordinated credits recognised by law (and only in limited circumstances) were participative loans (i.e. those equivalent to equity). Credits are considered to be subordinated credits in the following circumstances (i) credits held by specially related persons (including directors and creditors holding more than a 5% shareholding in a public company, or 10% in a private company) (a �Related Person�), (ii) shareholders� loans, (iii) intra-group loans, (iv) unsecured interest accrued on credits, and (v) credits contractually subordinated to all other credits (e.g. participative loans).

Banking Update. 7

When structuring any financing, it should be borne in mind that:

• Granting of security over a subordinated credit will not confer priority on such credit, which will continue to be subordinated to the rights of ordinary creditors. In addition the Act states that any existing security securing subordinated credits shall be cancelled. The Act is unclear as to whether the cancellation only affects security created by the insolvent debtor to secure its own subordinated debt.

• Spanish banks often have significant shareholdings in Spanish companies which means that they may be Related Persons. It is necessary therefore to include clauses in facility agreements modifying the calculation of the distribution of proceeds and the pro-rata sharing clauses, so as to avoid the risk that the amounts received by the other banks are reduced as a result of a Spanish bank lender under the facility being a Related Person of an insolvent debtor.

• The exercise of step-in provisions, restrictive covenants in facility agreements and the ability to appoint directors under certain circumstances may give rise to a determination that the creditor is a Related Person. These provisions should be considered carefully.

• Any assignment of credits made by a Related Person will affect the assignees, who will be considered subordinated creditors unless able to prove that they are not Related Persons and that the assignment has been made at arm�s length. This presumption affects assignments made during the period commencing two years prior to the declaration of insolvency.

Impact of declaration of insolvency on termination, acceleration and restatement of facility agreements

Facility agreements terminated early as a result of payment default during the three months prior to the declaration of insolvency can be reinstated provided that any outstanding amounts due and payable have been satisfied. The banks may prevent such reinstatement by filing legal actions to obtain payment against the insolvent debtor, any other joint and several debtor under the facility agreement or any guarantor.

In addition to the above, a declaration of insolvency of the debtor cannot in itself be considered an event of default of a contract with reciprocal obligations. If the insolvent debtor continues to comply with its payment obligations after the declaration of insolvency, the debtor will be entitled to continue to use any remaining commitments and the agreement cannot be accelerated or terminated early. As a result, it would be advisable to include specific contractual provisions in facility agreements with Spanish borrowers limiting amounts that may be utilised by any insolvent Spanish borrower.

Although the Act is not entirely clear in this respect, there is a view that this rule does not preclude the possibility of terminating early and accelerating

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term loans and facilities provided that, upon the declaration of insolvency, the lenders have no remaining commitments or the availability period for drawing of commitments has expired. The ability to accelerate these loans is critical to enable claims in respect of third party guarantees and security.

Interest provisions

Upon the declaration of insolvency, interest will stop accruing unless it is secured and the security documentation expressly provides for such accrual. It should be noted that, in cases where the credit agreement is maintained or reinstated, interest will continue to accrue as an insolvency credit (with priority over all creditors except secured creditors). Insolvency credits are paid when due and therefore the document should be drafted to include provisions in the facility agreement expressly shortening (or leaving lenders the discretion to set) interest periods on the occurrence of the debtor�s insolvency.

Set-off

Set-off is not permitted under the Act except in two circumstances: (i) if the requirements to effect set-off were met prior to the insolvency of the debtor (being that concurrent credits must be due, liquid and enforceable) and (ii) if the law governing the credit held by the debtor against its creditor allows set-off in insolvency situations.

Special provisions that apply to finance agreements

Certain financial transactions are not affected by the restrictions and presumptions of the Act, and will thus continue to be regulated by specific legislation. These include true sale of credits in factoring and securitisation transactions, operations in clearance and settlement systems and netting provisions on framework agreements for certain finance operations (including derivatives).

Andres Lorrio / Guillermo Yuste

Madrid

Banking Update. 9

The consequences of wrongful acceleration

The Court of Appeal recently considered whether the giving of a notice of acceleration by a bond trustee under a bond issue in circumstances where no event of default had actually occurred would give rise to a claim for damages by the issuer for breach of contract. Overturning the widely held view that a trustee or facility agent could be sued for damages for losses suffered by an issuer or borrower as a result of wrongful acceleration, the Court of Appeal held that the giving of notice further to a non-existent event of default meant that such a notice was contractually �ineffective� . An ineffective notice would not constitute a breach of contract and therefore there could be no cause of action for damages for breach of contract. The Court of Appeal in reaching this decision also made a number of other surprising comments which are discussed below in further detail.

Facts

Concord Trust held 10 percent of a bond issue, guaranteed by the issuer�s parent, a Polish telecommunications and energy company, Electrim (�E�). The bondholders nominee on the board of E was suspended. The Law Debenture, which was the bond trustee, notified E that this would constitute an event of default under the terms and conditions of the bonds if it was not remedied within 30 days, and subject to the trustee certifying that the suspension was materially prejudicial to the interests of the bondholders.

Having received court directions that it was materially prejudicial, more than 30% in value of the bondholders demanded that notice was given accelerating repayment of the bonds. The trustee was obliged under the terms of the trust deed to give notice to the issuer if requested to do so in writing by at least 30% of the bondholders and subject to being indemnified to its satisfaction.

The trustee refused to send in the notice as it regarded the indemnity offered by Concord was not sufficient for the magnitude of liabilities it could incur, which it considered to be in the region of up to a billion euros. It calculated this on the assumption that it would be sued for the economic cost suffered by the issuer if it accelerated on the basis of an event of default which had not actually occurred. The Law Debenture were aware that E intended to dispute that an event of default had occurred. Concord refused to provide an indemnity of such magnitude, arguing that it was unreasonable. Concord then applied to the Courts for a declaration that the Law Debenture was obliged to call an event of default and accelerate payment under the bond.

The High Court, however, refused to grant such a declaration. It ruled that the Law Debenture was not being unreasonable in requesting such a sizeable indemnity before accelerating, assessing that a �wrongful acceleration� could give rise to a claim by E against it for damages in the

Allegra Miles

December 2004 10

region of hundreds of millions of euro. This figure was based on the loss E would suffer as a result of a forced sale of its shareholding in a major telecommunications company (its only major asset) which would be triggered by the acceleration.

The Vice-Chancellor ruled that the relevant clause of the bonds and the trust deed which entitled the trustee to accelerate the bonds if there was an event of default, would be breached if the trustee gave notice requiring immediate repayment where there was in fact no event of default. Concord appealed against the decision.

Judgment

The Court of Appeal concluded that a notice purporting to accelerate but given at a time when no event of default had occurred would be ineffective to achieve its purpose, namely immediate repayment of the bonds. This was because such a notice was of no contractual effect between E and the trustee and E could choose to ignore it. The court then considered whether even if the notice was contractually ineffective, if the mere act of sending an acceleration notice where there is no event of default would give E a cause of action for damages for breach of contract or in tort. In assessing the contractual claim, the court ruled that there was no breach because there was no express term in the trust deed that the trustee would not give notice of acceleration where an event of default had not occurred nor could one be implied. Therefore with no contractual breach, there could be no claim for damages.

In considering whether a cause of action might arise in tort, the Court of Appeal was of the preliminary view that it would be difficult to see that a cause of action existed, absent bad faith. Finally, the Court of Appeal ruled that unless an event of default had actually occurred, the trustee was not obliged to send in the notice of acceleration, despite the requisite majority of the bondholders demanding it do so.

Analysis

At first sight, this decision appears beneficial for trustees and facility agents (as they cannot be sued for damages arising from sending in a notice of acceleration when no event of default has actually occurred) but of concern for issuers and borrowers who because of wrongful acceleration may find themselves with no legal recourse for loss or damages suffered as a direct result of such acceleration (other than the costs of litigation in resolving the issue).

However, this decision should be interpreted in light of and confined to the specific circumstances of the case. In this particular case, no acceleration notice had been sent and no adverse economic consequences had been suffered by the issuer other than the costs of litigating whether an event of default had actually occurred. The parties were in and out of court seeking

Banking Update. 11

clarification of the issues, and whether a notice of acceleration should be given.

Unfortunately, the court did not consider the more likely scenario of a notice of acceleration being given by, for example, a facility agent under a secured syndicated facility, which although it was �contractually ineffective� (as no event of default had actually occurred), by virtue of being sent and publicised caused the borrower�s other financings to cross default and enforcement of security with resultant damage to the borrower�s reputation, financial standing and ultimately possibly leading to its insolvency. In such a situation, economic damage would have flowed directly from the notice of acceleration, although the notice itself was contractually ineffective as a demand for immediate repayment. It would be manifestly inequitable and out of touch with commercial reality that in such a situation the borrower or its liquidator would have no cause of action for contractual damages despite the economic loss that flowed directly from the acceleration notice.

In view of the above, it would appear unlikely that the ratio of the Court of Appeal, namely that serving an ineffective notice of acceleration does not constitute a contractual breach and therefore there is no contractual claim for damages, would apply as a universal principle to every situation in which wrongful acceleration occurred, whatever the economic consequences.

The Court of Appeal did not address in detail over the issue of whether a cause of action might arise in tort, although it concluded that proving a cause of action was unlikely, bar some dishonesty or fraudulent conduct on behalf of the trustee. In order for a claim in tort to arise there would need to be a duty of care imposed on the trustee towards the issuer/borrower and it is questionable whether such a duty would be imposed following the relevant tests. This issue should hopefully be clarified by the House of Lords, if leave to appeal is given.

One further financing scenario which was not considered by the court was where lenders withhold funding because an event of default has occurred. Most loan agreements provide that the lenders only have an obligation to fund if no event of default has occurred or is continuing. If an event of default has not actually occurred and the lenders withhold funding, it is likely that there is a breach of contract and the lenders would be liable for consequences that flowed as a result of such a breach.

The House of Lords will hopefully consider both the correctness of the view reached by the Court of Appeal that an acceleration notice given when no event of default has occurred is contractually ineffective and therefore does not constitute a breach of contract, barring in turn a claim for contractual damages, and also the scope of its application when �wrongful acceleration� leads to manifest economic loss. Until such time, trustees and facility agents are well advised to treat this decision with caution.

Allegra Miles

London

December 2004 12

Power to mortgage under Belgian law

Introduction

A mortgage over real estate in Belgium entails registration costs that are relatively significant (approximately 1.5 % of the secured amount). Belgian banks have over time developed the practice of taking powers to mortgage instead of a mortgage in order to reduce these costs. This practice appears to be specific to Belgium (even though similar concepts may exist in other jurisdictions).

This practice has more recently spread to cross-border LBOs and other financings. There are, however, a number of risks associated with the taking of powers to mortgage. This article focuses on the creation of a power to mortgage and its advantages and disadvantages.

Creation of a power to mortgage

A power to mortgage is an agreement, executed before a notary, between the grantor and individuals (and, in some cases, a subsidiary of the lender) chosen by the lender whereby these agents (acting in their own name and not in the name of the lender) are granted the power to secure the lender's claim at any time in the future by registration of a mortgage over a specified property. The lender usually chooses a number of persons amongst its officers and employees, each of these receiving the power to act individually and to subdelegate.

Such power to mortgage is usually taken in addition to an actual mortgage covering part of the facility.

Advantages over mortgages

The main advantage of the power to mortgage is to reduce the costs to approximately 0.01% of the secured amount.

Additional advantages include:

• the grantor does not have to own the property at the time of the granting of the power to mortgage; and

• the time necessary for the creation of the power to mortgage is significantly shorter than for a mortgage (which usually requires one month).

Risks for the lender

Although there is a major cost advantage to the power to mortgage, it is not a robust alternative to security since it is not publicly recorded. Therefore, before the power to mortgage is used to create and register the mortgage, the lender is only an unsecured creditor.

Jacques Richelle

Banking Update. 13

A power to mortgage therefore presents the following risks for the lender:

• another creditor may be granted, and may record, a mortgage before the power to mortgage is used to create a mortgage;

• the debtor may sell the real property, and record the sale, before the power to mortgage is used to create a mortgage;

• if the power to mortgage is exercised during the hardening period (i.e., up to six months before the declaration of insolvency), the mortgage will be declared null and void as a new security interest securing an existing debt; and

• after the insolvency of the debtor, the creation mortgage may no longer be recorded.

In order to mitigate these risks, powers to mortgage and/or facility agreements usually provide appropriate representations and undertakings from the grantor (e.g. confirmation of the absence of any other such power, prohibition to sell the assets or to grant other mortgages or powers to mortgage).

Power to pledge business assets

The practice of granting a power to mortgage extends to a pledge of business assets (�gage sur fond de commerce/pand op handelszaak�). The power to mortgage business assets has the same advantages (though the costs of a pledge over business assets are less significant, approximately 0.6% of the secured amount) and the same disadvantages for the lender as detailed above.

Conclusion

Although the power to mortgage is advantageous in that it reduces costs, lenders should be aware that this approach is far from robust, and they should be aware of the risks attached to relying on a power to mortgage, without taking additional security.

Jacques Richelle

Brussels

December 2004 14

Financial Collateral Act in Poland

The Financial Collateral Act of April 2004 (the �Act�) sets out the rules on the creation and enforcement of financial pledges. These rules allow Polish banks, banks carrying on business within the EU and certain other entities the right to establish and/or take a financial pledge.

One important restriction in the Act is that a financial pledge may only be entered into between professional market participants.

This article outlines the new rules on the creation and enforcement of financial pledges.

Description of a financial pledge

A financial pledge can be taken over both monetary receivables and rights deriving from financial instruments. The Act defines �financial instruments� as securities, banking securities, shares and participation units in investment funds.

There are certain mandatory provisions which must be included in the financial pledge agreement in order for it to be valid. These include the enforcement events, the manner of valuing the subject of the financial pledge (except for publicly traded securities) and the rules of settlement between the parties to the agreement.

The Act also specifically allows for a financial pledge agreement to include certain provisions, such as (i) a compensation clause (discussed below), (ii) a provision allowing the pledgee to satisfy its claims by taking ownership of the subject of the pledge and (iii) a provision permitting the pledgor to replace the subject of the pledge with certain other receivables and/or financial instruments. These clauses, if included, provide a degree of flexibility which makes a financial pledge an advantageous form of security.

As mentioned above, the parties to a financial pledge agreement can agree on a �compensation clause�, which provides that settlement will be based on the net difference between their mutual receivables. This type of settlement, as opposed to set-off, is possible even if no receivables of the parties are then due and payable.

All Polish law agreements which establish an ordinary pledge over rights require notarisation. However, another advantage of the financial pledge agreement is that it does not require notarisation.

Ways in which the pledgee�s claims may be satisfied

In an enforcement event, the pledgee has three routes open to it to enforce the financial pledge and realise the proceeds of the pledge. The first is a sale of the subject of the financial pledge. The second is by set off and/or compensation and the third by taking ownership of the subject of the

Adrian Horne

Marta Natalia Zbikowska

Banking Update. 15

financial pledge. If the pledgee takes ownership of securities traded on a regulated market, these should be valued as at the end of the day on which title passes. Court intervention is not required using any of these three enforcement routes and therefore enforcement is relatively quick and easy for the beneficiaries of a financial pledge.

Dematerialised securities

The Act also provides that any agreement establishing security over dematerialised securities must be governed by the law of the country in which the relevant depositary account, securities account or other register of securities (in which such security is registered) is kept. The same law governs any rights resulting from such security, the priority of these rights and the way in which the pledgee may satisfy its secured claims.

Conclusion

The new law on financial pledges gives market participants a robust, flexible and easily enforceable form of security over shares, receivables and other financial instruments.

Adrian Horne / Marta Natalia Zbikowska

Warsaw

December 2004 16

Basel II and impact on loan documentation

Introduction

For some time, it has been clear that the capital adequacy principles originally established by the Basel Committee on Banking Supervision, and set out in the 1988 Basel Accord required reform to provide a more sensitive and flexible measure of credit risk. In April 2003, the Basel Committee issued its third Consultative Document, �the New Basel Capital Accord�, containing proposals for the replacement of the 1988 Basel Accord with a new set of standards designed to remove some of the market-distorting incentives of the current rules. These proposals have now been finalised and published by the Basel Committee in a document entitled �The International Convergence of Capital Measurements and Capital Standards: a Revised Framework� (�Basel II�), which are due to be implemented in the UK by the start of 2007.

This article will briefly outline the revised approach to credit risk weightings under Basel II, other relevant changes and the practical impact of Basel II on loan documentation.

Credit Risk Weightings

Current Approach

Currently, the amount of regulatory capital a bank is required to hold in respect of its balance sheet positions in the banking book is determined on the basis of a nominal likelihood of default. This is achieved by applying a �risk weighting� which is a specified percentage of the value of the position, representing an estimate of the degree of risk associated with it depending upon the identity of the counterparty and the likelihood of default. Under Basel I, the risk weightings range from 0% for cash and claims against certain highly rated governments and central banks to 100% for exposures to any corporate, no matter how highly rated. Therefore even if the corporate counterparty is rated AAA the risk weighting remains 100%. This inflexible and insensitive measure of credit risk has been overhauled by the new approach to credit risk in Basel II.

Revised Credit Risk Weightings under Basel II - Standardised Approach or IRB

Under Basel II, banks must adopt one of two main approaches in calculating regulatory capital requirements for credit risk. The simplest approach, which relies on external ratings from rating agencies, is called the �standardised approach�. The alternative approach uses the banks� own internal ratings.

Allegra Miles

Banking Update. 17

Standardised approach

Banks following the standardised approach will have risk weights assigned to their exposures to various types of counterparty based on assessments by external credit rating agencies. A distinction will continue to be drawn between sovereigns, banks and investment firms, and corporates (and certain other categories), but in all cases the credit rating of the entity will be the primary determinant of the amount of regulatory capital that has to be held. The risk weightings for exposures to corporates and sovereigns are set out below.

Corporates attract a risk weighting depending on their credit rating, as set out in the grid below.

Credit Assessment AAA to AA-

A+ to A-

BBB+ to BB-

Below BB-

Unrated

Risk weighting 20% 50% 100% 150% 100%

The risk weighting for exposures to sovereigns is divided by credit rating as follows:

Credit Assessment AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to B-

Below B-

Unrated

Risk weighting 0% 20% 50% 100% 150% 100%

Whilst the ratings in the standardised approach provisions are based on Standard & Poor�s credit ratings, the ratings of any agencies approved by national supervisors will be permissible as a basis for the standardised approach (subject to some overriding criteria).

Internal ratings

The alternative to the standardised approach is to use the banks� own internal estimates of risk components in determining the capital requirement for a given exposure. This is called the internal ratings based (�IRB�) approach, of which there are two variants: a �foundation� approach and an �advanced� approach. Under either IRB approach, banks must categorise banking book exposures into broad classes of assets with different underlying risk characteristics. The classes of assets are (a) corporate, (b) sovereign, (c) bank, (d) retail and (e) equity. Within the corporate asset class, five sub-classes of specialised lending are separately identified. The risk weights are determined through the combination of quantative inputs provided by banks, and formulas specified by the Basel II Committee.

December 2004 18

The four quantitative inputs are:

• the probability of default associated with the borrower (�PD�);

• the expected exposure on a default (�EAD�);

• the loss that would arise if default occurred (�LGD�), and

• impact on maturity (�M�).

Whilst PD would be assessed by the bank under both approaches, only the advanced approach would permit the bank to use its own models to assess the three other criteria. Under the foundation approach, which has lower eligibility criteria, regulators would set values for these three criteria. Banks selecting either IRB approach will be allowed a transitional period from the date of implementation.

The actual formula for calculating the capital requirement for any given exposure is complex. Broadly, the PD figure is adjusted by a correlation factor and a maturity factor and applied to the LGD. If a figure for risk weighted assets is required, then this is effectively reverse calculated by multiplying the capital requirement by 12.5 (the reciprocal of 8%) and the EAD.

Other credit risk changes

364 day facilities

Under Basel I, 364 day facilities qualify for zero weighting and therefore banks do not need to set aside regulatory capital for their commitment under such facilities. However, Basel II makes changes to the regulatory capital treatment of 364 day facilities under both the standardised and IRB approach. Under the standardised approach, the 0% credit conversion factor (�CCF�) (which is applied to off-balance sheet items (e.g. commitments to lend) to convert such items into conceptually equivalent on balance sheet exposures) will be abolished for 364 day facilities, and replaced by a 20% CCF. A 0% CCF will, however, remain where the facility is unconditionally cancellable by the bank without prior notice. Facilities with an original maturity of over one year, and not cancellable on demand, will still be subject to a 50% CCF.

Under the IRB approach, 364 day facilities will qualify for a 75% CCF, unless the facility is unconditionally cancellable without prior notice, in which case it will qualify for 0% CCF.

Specialised lending

There are 5 specialist sub-categories within the corporate asset class under the IRB approach; project finance, object finance (i.e. asset finance), commodities finance, finance for income producing real estate, and finance for high volatility real estate. If banks cannot estimate the probability of default for these types of exposure then they must allocate them into 5

Banking Update. 19

categories, each of which is attributed a specific risk weighting. Generally, the risk weighting for specialised lending is greater than 100%.

Credit risk mitigation

A wider range of collateral will qualify to mitigate regulatory capital requirements. Eligible collateral will now include debt securities (either meeting specified credit ratings or issued by banks where listed and unsubordinated), equities included in �a main index� and units in Collective Investment Schemes. There are a number of additional procedures required to ensure that such collateral is eligible. However, there continues to be no recognition of any benefit from the lower risk of a double default of both the underlying obligor and the credit protection provider.

Impact of Basel II on Loan Documentation

Increased costs

Under the LMA standard form documentation, a bank could make a claim under the increased costs clause for any additional costs incurred as a result of the reforms if they result from a change in law or regulation during the life of the facility. In the case of loan agreements with corporates of lower than BB- rating which will mature after January 2007 (the expected date for implementation of Basel II), the capital charge for the loan will increase for all banks (as the risk weighting is over 100% on both the IRB and standardised approach). Banks will therefore be able to reclaim this increased charge under the increased costs clauses. However, banks may not wish to rely on increased costs clauses as an increased cost will normally permit the borrower to prepay the bank and the banks will have a duty to mitigate. Also, subsequent rating changes will not be covered by the increased costs clause, since the change in law or regulation will have occurred and the increased costs clause does not normally cover changes in fact.

The drafting of increased costs clauses may therefore change after the introduction of Basel II, so as to catch increased costs from change of fact as well as change of law, and to remove the individual prepayment risk, and the mitigation obligation, where the increase results from (for example) a downgrade of the borrower. Alternatively, banks are likely to require pricing grids so that subsequent changes in credit ratings are reflected in the margin (as discussed below). A borrower may also argue that provisions should be made in the loan agreement for it to receive the benefit of decreased costs (e.g. an upgrade of its credit ratings) but banks are likely to resist this unless incorporated into a pricing grid.

December 2004 20

Carve-outs from increased costs clause

As discussed above, under the LMA standard form documentation increases in the regulatory capital cost to a bank of loan facilities which mature after January 2007 and which result from the introduction of Basel II, should be covered by the increased costs clause.

However, since the publication of Basel II, well-advised borrowers negotiating new loan agreements are arguing that any increased cost arising from the introduction or implementation of Basel II should be excluded from the scope of the increased costs clause. Their reasoning is that banks should now be able to calculate how the regulatory capital cost of the loan may change after the implementation of Basel II and that they should not be able to recover such costs if they can be built into the pricing of the loan. However, as discussed below, building a mechanism into the loan agreement to recover any increases in the regulatory capital cost of a loan as a result of Basel II is complex in particular for those banks using the IRB method. This is because the quantitive criteria are not yet available and each bank in a syndicate might produce different risk weightings for a loan to the same borrower.

Banks are therefore resisting a blanket Basel II carve-out to the increased costs clause. However, some strong borrowers are starting to successfully negotiate a compromise provision in the increased costs clause. This is that if a lender makes a Basel II increased costs claim, the parties will enter into negotiations in good faith with a view to agreeing whether the costs should be paid, and until agreement is reached, the borrower cannot prepay or replace that lender. Whether the inclusion of such wording becomes more common in loan agreements entered into between now and January 2007 remains to be seen as market practice in this area develops.

Pricing

In its simplest form, a pricing grid could be built into the loan agreement whereby the borrower would pay an add-on to the margin based on its credit rating or risk weight. This would become more complex if banks used their internal ratings to determine risk weights. For example, members of a syndicate might produce different risk weightings for the same borrower in respect of the same exposure, depending on which approach they are using. It is unlikely that pricing grids could deal with this level of detail. An alternative might be for the schedule calculating �associated costs� to be revised so that the Agent would calculate the additional amount to be paid by the borrower based on the risk weightings provided by each syndicate member for the relevant exposure. Banks and borrowers are likely to prefer the certainty of this alternative approach.

Banking Update. 21

Conclusion

The implementation of Basel II will have a major impact on the regulatory capital treatment by banks and other financial institutions of loans to all counterparties, in particular, corporates. Market practice has not yet developed as to the treatment of Basel II in loan agreements, although some of the options outlined above, such as a pricing grid may become more widely used as the timetable for implementation of Basel II in 2007 draws closer.

Allegra Miles London

December 2004 22

New Private International Law Code in Belgium

A new Belgian Private International Law Code came into force on 1 October 2004. The Code consolidates a number of existing provisions previously found in a variety of legislation. It also modifies a number of rules. Some of the new rules are relevant to banking transactions. They include, in particular, the following:

• The effectiveness of a pledge over receivables against third parties (other than the debtor) is governed by the law of the pledgor�s main establishment. As regards effectiveness against the debtor, the rule remains the same, namely that it is governed by the law applicable to the pledged receivable.

• The Code recognises, to some extent, a trust and the choice of a foreign law to govern the trust. It does not go as far, however, as recognising the trustee as a beneficiary of a Belgian law security interest. The need for a parallel debt structure in certain circumstances remains.

• The conditions for recognition of a foreign judgment in Belgium (where the judgment was rendered by a court outside the EU) have changed. Belgian courts no longer have the duty to review the merits of the case. They have, however, new grounds to reject such recognition, for example, if there is a decision by, or pending proceedings before, a Belgian court on the same issue.

• Belgian courts may accept jurisdiction notwithstanding the choice of foreign courts if proceedings have already been commenced in a closely connected dispute or if the dispute is closely connected to Belgium and litigation abroad appears to be impossible or unreasonable.

• Belgian courts may decide to apply Belgian law notwithstanding the choice of a foreign law in the contract if it is impossible to determine the content of the foreign law within a reasonable timeframe.

Jacques Richelle / François Guillaume de Liedekerke Brussels

Jacques Richelle

François Guillaume de Liedekerke

Banking Update. 23

How new tax disclosure rules affect lending transactions

The Finance Act 2004 contains legislation (the �Disclosure Regulations�) requiring certain tax based �notifiable arrangements� to be disclosed to the Inland Revenue. That disclosure obligation will often fall on persons other than the actual beneficiary of the tax advantage in question. In addition, the disclosure obligation can arise even before any of the parties to the arrangement have actually implemented a transaction.

This article does not focus on how these rules impact on the �tax-based financing� or �structured products� divisions which many banks operate. Banks will doubtless already have received detailed and specific advice on the implications of the disclosure rules in this area. Rather, the purpose of this article is to address how the disclosure rules could apply to a bank�s general banking business.

Overview of the Disclosure Regulations

The Disclosure Regulations are best understood by answering the following three questions:

• What types of arrangement need to be disclosed?

• Who needs to make a disclosure?

• Within what time period does a disclosure have to be made?

What types of arrangement need to be disclosed?

An arrangement is potentially disclosable if it involves a specified �financial product� and the main benefit, or one of the main benefits, that might be expected to arise from the arrangement is the obtaining of a �tax advantage�.

The list of specified financial products is extremely wide. Any arrangement involving a loan, a derivative or a share will involve a specified financial product. Similarly, �tax advantage� is widely defined although importantly it covers only UK tax benefits. It would include, for example, a straightforward UK deduction for interest or for sums paid under a derivative. Therefore, in most cases the key question will be whether the arrangements truly do have a �main benefit� of securing a tax advantage.

In straightforward situations even if an arrangement does give rise to �tax advantages� those advantages will not be a �main benefit�. A bank lending to a UK borrower under a straightforward loan will know that the borrower expects a tax deduction for interest that it pays. Similarly, the bank will expect a tax deduction for its own funding cost. While these are �tax advantages� as defined they are not a �main benefit� of the loan in question.

Jonathan Richards

December 2004 24

The borrower will typically have a commercial benefit that it expects to obtain by borrowing the money. The bank�s �main benefit� is its margin.

However, the position could be less straightforward. For example, a borrower may have devised a tax-driven structure which it expects to deliver it UK tax benefits. An integral component of that structure may involve borrowing money in a particular company or in a particular way. Even though the lender may be completely unaware of this, the �arrangement� as a whole might, from the borrower�s perspective, have tax as its �main benefit�.

Therefore, banks that �lend into� structures that are known to have a UK tax benefit should not assume that, simply because they are entering into that loan in the ordinary course of their business, there is no question of the structure being a �notifiable arrangement�.

Who needs to make a disclosure?

�Users� of tax based arrangements have an obligation to disclose in certain circumstances.

However, of more interest to banks entering into general banking business will be the disclosure obligation that falls on �promoters�. There are two categories of �promoter�:

• �Marketers� � these are people who make an arrangement �available for implementation�. While this limb of the �promoter� definition may well apply if a bank is marketing a particular product through its structured products division or to high net worth individuals through its private bank, it will typically not be relevant to a bank making a commercial loan in the course of its general banking business.

• Persons who are �to any extent responsible for the design of� the arrangements are also promoters. That test does not just focus on the �tax component� of the arrangements. Therefore, if a lender is being asked to lend into a structure in a particular way, and the lender helps to ensure that part of the structure �works� from say a set-off or credit perspective that bank could potentially be regarded as having some responsibility for design even if it is not involved at all in the tax structuring.

These definitions are subject to two qualifications which are likely to be important to banks engaging in ordinary course banking activities:

• The �Group Tax� function in a banking group is not a �promoter� to the extent that it provides services to other members of the �group�. At the margins, tax advisory services provided to joint venture companies might not benefit from this exception if the joint venture is not a member of the �group�. However, in most cases, if Group Tax require a loan to be structured in a particular way to satisfy the bank�s own internal tax requirements, that is unlikely to trigger a disclosure obligation on the bank.

Banking Update. 25

• A bank is not a �promoter� if, while it is to some extent responsible for the design of particular arrangements, it is not responsible for the design of the entirety of those arrangements and could not reasonably be expected to know whether the scheme is notifiable or not. Therefore, if a bank is being asked to �lend into� a structure giving a tax benefit, it is likely to benefit from this defence provided that it does not assume responsibility for the design of the arrangements as a whole and does not get too deeply involved in the tax aspects of the transaction.

When does disclosure have to be made?

If a bank is a �promoter�, then, in the case of ordinary course lending, the most likely date for notification is five days after the bank becomes aware that any transaction in pursuance of the arrangements has actually been implemented.

If there is more than one �promoter� involved, then disclosure by one promoter satisfies the obligations of all promoters.

Practical points

The following practical points emerge:

• The Disclosure Regulations are unlikely to apply to a straightforward lending by a bank where the bank is not on notice that there is an underlying transaction providing a tax benefit.

• Occasionally, banks may be lending in circumstances where they know that particular UK tax benefits are being sought as part of a wider arrangement of which the borrowing forms part. In those circumstances, a bank should satisfy itself that the nature of its role in its transaction means that it is not a �promoter�. If the bank has only a tangential structuring role and is unaware of the precise tax benefits arising and how they are to be obtained, the bank will generally be able to conclude that it is not a �promoter�.

In the (exceptional) circumstances where a bank�s ordinary course participation in a transaction does make it a "promoter�, it may find that it would be more appropriate for another �promoter� (perhaps a person who marketed the transaction in the first place) to make the disclosure. In those cases, the bank will probably simply ask to have the opportunity to review that disclosure before it is submitted.

Jonathan Richards London

December 2004 26

Public private partnerships in France

Simon Ratledge from our Paris office picks up where we left off in the article on PPP reform in France, Banking Update, May 2004 edition

The past six months have seen public private partnerships (�PPPs�) building up significant momentum in France.

The high point of the summer was the adoption of the long awaited Government Order on �partnership contracts�, the French answer to the PFI. In October, the Conseil d�Etat, the highest court in administrative law matters in France, dismissed challenges to this Order and a decree was passed establishing a taskforce, attached to the Ministry of Economy and Finance, to assist public participants in evaluating, negotiating and implementing partnership contracts. A practical guide to the �partnership contracts� is expected to be released in the coming weeks.

In terms of sector-specific reforms, the Ministry of Justice�s ambitious prisons program is now well under way, with pre-selected bidders having been confirmed on the first batch of four PPP prisons at the end of November. The decentralised hospitals programme is now also picking up speed, with a number of sizeable projects reaching the market.

2005 promises to be an interesting year for PPP participants in France.

Simon Ratledge Paris

Simon Ratledge

Banking Update. 27

28

This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters, or contact the editors.

© Linklaters. All Rights reserved 2004

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Editors: Jeremy Stokeld Email: jeremy.stokeld@linklaters.com Allegra Miles Email: allegra.miles@linklaters.com

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