Asset-Based Lending and Insolvency

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Asset-Based Lending and Insolvency

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1. Asset-Based Lending and Insolvency

2. 1 Asset-Based Lending and Insolvency by Andrew Knight and Grant Jones of Squire Sanders & Dempsey, published by Spiramus Press Ltd (www.spiramus.com)

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26. 25 Case Study 1: Background Borrower: English-registered manufacturing company Registered office, HQ and factory all located in England Small branch in Ireland: holds some finished goods inventory acts as local sales office Owns a parcel of real estate in Germany and plans to open a branch there but has not yet done so. Seeks funding against: receivables and inventory (England and Ireland) real estate (England and Germany)

27. 26 Case study 1: where’s COMI? “…COMI must be interpreted as the place where the debtor conducts the administration of his interests on a regular basis and is therefore ascertainable by third parties…the [regulation] presumes, unless proved to the contrary, that the debtor’s COMI is the place of his registered office.” (Virgos-Schmit Report) The debate over COMI Check the English borrower is not just a “letterbox company”: Directors should (in the main) be local to the registered office jurisdiction (i.e. England) Local directors should exercise considerable control (but need not micro-manage) It should be clear to creditors that control is exercised locally.

28. 27 Case study 1: what are the assets Real estate real estate mortgages common and straightforward pretty much everywhere Inventory non-possessory security interest required floating charge concerns in England and Ireland Receivables security or debt purchase preferred? with- or without-recourse debt purchase? do you have a choice?

29. 28 Case study 1: where are the assets? England take a debenture (fixed and floating charge)? Real estate: freehold or (valuable) leasehold: take a legal mortgage Inventory: purported fixed charge probably a floating charge? realistic alternatives? chattel mortgage: remotely workable? better for PM&E? pledge: does the business model accommodate it? Receivables with recourse debt purchase receives favourable legal treatment in the local courts are there any export debts?

30. 29 Case study 1: where are the assets? Ireland (inventory and receivables) Good news local laws on taking security and debt purchase are remarkably similar to English law Bad news it’s a different country! the concept of ‘local perfection’ the ‘lex situs’ of assets problems with the ‘lex situs’ intangibles don’t have a location registered movable assets (e.g. ships) debtor-indexed systems (e.g. UK and US)

31. 30 Case study 1: where are the assets? Inventory generally accepted that inventory is subject to the law of its current location Irish law security required over Irish-located inventory, regardless of the fact that the chargor is English are we covered if inventory is in transit? we might need to register security twice: under English law (UK Companies Act) under local law (Irish Companies Act applicable to foreign companies with a branch or place of business registered in Ireland) – ALWAYS CHECK

32. 31 Case study 1: where are the assets? Inventory (continued) can’t we just rely on the English law security documents? local perfection adds to cost we may get lucky – with Ireland – our English security interest may tick the boxes to ensure validity under Irish law as equally as under English law other countries will not be so user-friendly. don’t forget: “local perfection” frequently implies taking local security in the first place - not merely registering/notifying your English security on a local basis! local perfection enhances the lender’s rights on insolvency, as a result of the way in which the Insolvency Regulation operates

33. 32 Case study 1: where are the assets? Receivables generated by the branch (i.e. owed to the English company) can we not just use the English DPA that we were taking anyway? ‘lex situs’ of receivables – governing law has come to supplant the old preference for the law of the account debtor’s location……but art 2(g) of the Insolvency Regulation provides that a ‘claim’ is located where the third party obligor has its own COMI examine the contract between the English company and each account debtor if English law applies, rely on the English DPA or look deeper? local law perfection; determine requirements (e.g. notice?) (analogous principles apply to taking security over receivables)

34. 33 Case study 1: where are the assets? Germany (real estate) probably a universal principle that land is subject to the law of its location here, German law security is required attempt to rely on English law charge doomed to failure: Germany not analogous to Ireland: no close similarity to English law (and there would likely be problems with security over land in Ireland, also) rules on form, formalities, land registry requirements, language: English law charge will not “tick the boxes” don’t forget: double registration requirements? England (UK Companies Act) Germany (Land Registration)

35. 34 Case study 1: insolvency laws – England Which country’s law will govern “main proceedings” ? English law will almost certainly apply here because there is little room for doubt about COMI What are the asset-based lender’s options in England? unless and until main proceedings have been opened in England, the lender will likely have the full range of security enforcement rights available to it (for example, the right to appoint an LPA receiver) but if an administration order is made in England (and, as is likely) the administration constitutes ‘main proceedings’, the lender is subject to the statutory moratorium under UK insolvency legislation, which will prevent most enforcement options (but NB. the right to collect-out purchased debts arising prior to the commencement of administration) if a winding-up order is made in England, the statutory moratorium does not apply

36. 35 Case study 1: insolvency laws - Ireland What happens as regards the Irish assets (inventory and receivables)? assume ‘main proceedings’ have been commenced in England and no secondary proceedings have been commenced in Ireland asset-based lender may rely on Insolvency Regulation, art. 5: excludes from the effect of main proceedings “rights in rem” of third parties and creditors in respect of assets located in a member state other than that where main proceedings are opened the relevant time for determining location is the time at which main proceedings are opened: keep an eye on that inventory! interesting question whether the moratorium imposed by an English administration has extra-territorial effect – but this does not defeat a lender’s art. 5 rights.

37. 36 Case study 1: insolvency laws - Ireland ABL is therefore free to exercise enforcement rights against assets in Ireland regardless of the commencement of insolvency proceedings in England the English IP may want to fight back: as the Borrower has an establishment (not merely assets) in Ireland, the IP is entitled to commence “territorial” or secondary proceedings in Ireland the asset-based lender’s rights under article 5 in respect of Irish assets do not override the secondary proceedings opened in the same country if relevant proceedings impose a moratorium on security enforcement in Ireland, the lender will be subject to that moratorium but it so happens that (in the case of Ireland) the relevant proceedings (company examinership) are not permitted by the Insolvency Regulation as secondary proceedings

38. 37 Case study 1: insolvency laws - Ireland some important points the art 3(1) principle of universal main proceedings continues to apply: the lender must still account to the insolvent estate for surplus enforcement proceeds how do insolvency priorities work? art 4 provides that the law of the country of main proceedings determines, inter alia, the ranking of claims and distribution of proceeds under English law, liquidation expenses and (the few remaining) preferential debts rank ahead of floating charge holders… …but art 5 states that the opening of (English) main proceedings is not to affect the lender’s “rights in rem” in respect of assets located in another member state (Ireland)

39. 38 Case study 1: insolvency laws - Ireland better view is that Irish law will determine the priority of lender’s floating charge as against prefs and expenses not totally free from doubt, due to uncertainty whether ranking of floating charge against prefs and expenses is a product of insolvency law or of the law relating to security importance of establishing which assets are “located” in Ireland: remember the points made earlier concerning local perfection of security over receivables and inventory and art 2(g) of the Insolvency Regulation if we want to rely on our art 5 rights, we need to have security that is perfected as a matter of Irish law over assets that are deemed by the Insolvency Regulation to be located in Ireland

40. 39 Case study 1: insolvency laws - Germany there is no local establishment in Germany the IP has no right to apply for secondary proceedings in Germany therefore: any moratorium imposed by English main proceedings will not apply (art 5) asset-based lender can enforce security outside the insolvency proceedings… …but any such enforcement must be carried out under German law, using German enforcement processes therefore critical part of the planning process is to understand how German security enforcement works and the likely costs

41. 40 Case study 1: defining the exit strategy exercise independent from any external exit strategy report that may be commissioned intended less to reassure underwriters that an exit exists, but rather to ensure that: the significant cross-border risks are identified and understood risks are reflected in the deal structure and documentation so far as is realistic and cost-effective using the principles outlined so far, aim to identify major asset classes by location and ownership, and determine what local perfection steps are required, taking into account the probable COMI of the asset-owning entity ensure that local enforcement and insolvency procedures and pitfalls are understood actual exit strategy may be a product of the external report (if any) and the above process

42. 41 Case study 1: defining the exit strategy Applying the approach to this case study: COMI likely to be in England have we checked it isn’t just a letterbox? English security fixed and floating charge receivables – DPA (but don’t forget export debts) Inventory – do we rely on the charge in the F&FC? Or take enhanced security? real estate – mortgage consider English reserves: prefs, prescribed part (floating charge) and other usual deductions

43. 42 Case study 1: defining the exit strategy Irish security fixed and floating charge receivables – rely on the English law DPA? where are the company’s “Irish” receivables really “situated” for legal purposes? contract law –v- location of the account debtor under art 2(g), if art 5 protection required obtain breakdown by location and contract law in order to assess cost-benefit of local perfections: if three small debtors are located in Italy, then it may be more sensible to treat relevant debts as ineligibles or control risk by concentration limits if three major debtors are located in Germany, then it may be worth perfecting not only under the contract law but also in Germany (N.B. how will German law treat our DPA? Will it rank ahead of or behind RoT creditors? Who will collect out?)

44. 43 Case study 1: defining the exit strategy Irish security (continued) Inventory: similar thought process to England do we have a fixed or floating charge? Is there a case for taking enhanced security? Inventory location English and Irish law coincide: law governing effective creation of security is the law of the place where inventory is located at time security was created when is security created on future goods? Insolvency Regulation, art 2(g): agrees with the physical location approach but relevant time to benefit from art 5 protection is the time when the main proceedings were opened, not the time when the security was created

45. 44 Case study 1: defining the exit strategy Irish security (continued) Consider cost-benefit of obtaining art 5 rights: remember the IP can open secondary proceedings in Ireland (because there is a local establishment) in this particular case, available secondary proceedings do not result in a moratorium but in other countries, secondary proceedings frequently will impose a moratorium in such cases the lender cannot enforce locally anyway difficult call in each case, but in this particular case study, Germany creates an interesting example of why the additional effort of multiple perfections might be justified When setting reserves, take into account the decisions made above - Irish law may apply rather than English law to typical reserves items.

46. 45 Case study 1: defining the exit strategy German security (real estate) no local establishment (= no secondary proceedings) real estate security really has to be made and perfected under German law in any case (but art 5 rights would also accrue) in less clear-cut cases, the fact that secondary proceedings could not be brought could make art 5 rights an extremely powerful weapon: imagine the scenario if accounts receivable were owed by German-COMI debtors to the English or Irish operations; art 2(g) would classify the receivables as being situated in Germany; art 5 would confer protection against the English main proceedings local perfection in Germany might well be advantageous……provided we accept the necessity to enforce in accordance with German laws, and understand what that entails German reserves (in this case) will be dependent on German law issues: obtain advice on claims that will rank in priority to the German real estate mortgage upon enforcement

47. 46 Case study 2: background Borrowers: English-registered company and Italian-registered subsidiary – both service providers Each company has its own registered office, and its own operations, in its jurisdiction of incorporation Each company owns its own real estate. The companies seek funding against: receivables real estate Important: regulatory issues disregarded

48. 47 Case study 2: where’s COMI? EC Regulation on Insolvency Proceedings (the “Insolvency Regulation”) applies in both countries Each company has its own COMI. COMI for both companies could, however, be in a single jurisdiction Principles for establishing COMI: the presumption in favour of the registered office jurisdiction rebutting the presumption: the Eurofoods decision does the fact that the parent company is English make a difference?

49. 48 Case study 2: what are the assets Real estate real estate mortgages common and straightforward in England and Italy Receivables security or debt purchase preferred? with- or without-recourse debt purchase? do you have a choice? England: yes (floating charge hazard) Italy: yes (regulatory hazard – even when two-stepping)

50. 49 Case study 2: where are the assets? England Take a debenture (fixed and floating charge)? Real estate: freehold or (valuable) leasehold: take a legal mortgage Receivables with recourse debt purchase receives favourable legal treatment in the local courts are there any export debts?

51. 50 Case study 2: where are the assets? Italy Real Estate probably a universal principle that land is subject to the law of its location here, Italian law security is required Receivables choice between debt purchase (assignment) and security (in the form of a pledge) reminder: receivables may not be situated in Italy contract law -v- law of the account debtor’s COMI jurisdiction (art 2(g) of the Insolvency Regulation)

52. 51 Case study 2: insolvency laws – English company Assuming English company’s COMI is found to be in the UK, English law will govern ‘main proceedings’ What are the asset-based lender’s options in England? much as in case study 1 unless and until main proceedings have been opened in England, the lender will likely have the full range of security enforcement rights available to it (for example, the right to appoint an LPA receiver) but if an administration order is made in England (and, as is likely) the administration constitutes ‘main proceedings’, the lender is subject to the statutory moratorium under UK insolvency legislation, which will prevent most enforcement options (but NB. the right to collect-out purchased debts arising prior to the commencement of administration) if a winding-up order is made in England, the statutory moratorium does not apply

53. 52 Case study 2: insolvency laws – Italian company If COMI is in Italy, Italian law ‘main proceedings’ may be opened, in which case the insolvency will be governed by Italian law Prior to commencement of Italian main proceedings, asset-based lender may enforce its (Italian law) assignment or its pledge, but only in accordance with Italian law: Assignment typically enforced by notice to account debtors followed by direct collection Pledge enforcement requires service of notice to the Italian company: Italian company likely to object as a matter of formal procedure application must then be made to court for an enforcement order

54. 53 Case study 2: insolvency laws – Italian company If COMI is in Italy and Italian law ‘main proceedings’ are opened, the insolvency process (‘bankruptcy’) will be governed by Italian law Italian receivables pledges must be notified to account debtors by no later than the date on which the company’s bankruptcy order in order to be enforceable as against the bankruptcy official Italian bankruptcy imposes a moratorium on security enforcement (analogous to the English law moratorium in administration) But by way of exclusion, Italian bankruptcy law also permits a pledgee of debts to collect in proceeds and reduce the secured indebtedness unless the bankruptcy court decrees otherwise (e.g. on application by the local IP)

55. 54 Case study 2: insolvency laws – Italian company What if the Italian company’s COMI is found to be in the UK? English insolvency procedures become available, e.g administration but as regards assets (receivables and real estate) located in Italy, the asset-based lender may rely on Insolvency Regulation, art. 5: reminder: excludes from the effect of main proceedings “rights in rem” of third parties and creditors in respect of assets located in a member state other than that where main proceedings are opened unless until English IP applies for Italian bankruptcy as secondary proceedings, the asset-based lender may continue to enforce its Italian security rights - under Italian law and procedure

56. 55 Case study 2: defining the exit strategy Italian company’s security If COMI is considered likely to be in the UK: we cannot just ignore local laws in Italy Italian law perfection remains important to ensure valid security/debt purchase over Italian assets, but is not guaranteed to avoid moratorium - remember the IP can open secondary proceedings in Italy (because there is a local establishment) secondary proceedings in Italy (in the form of an Italian bankruptcy): will give rise to a moratorium under local law reliance on art 5 will not avoid the moratorium

57. 56 Case study 2: defining the exit strategy Italian company’s security (continued) Consider cost-benefit of obtaining art 5 rights as regards receivables – careful analysis required: if created by Italian law contract, good security/debt purchase can be created under Italian law but if owed by an account debtor in a third member state where the company has no establishment, consider perfecting there also if value justifies cost art 2(g) locates receivables there for the purposes of the Insolvency Regulation English IP cannot open secondary proceedings in the relevant country When setting reserves, take into account the decisions made above - the law of the third state may apply rather than English law or Italian to typical reserves items.

58. 57 Case study 2: defining the exit strategy Consequences of not perfecting locally in the case of either company, if receivables are governed by the law of country other than the jurisdiction of incorporation (export debts), the temptation may be not to perfect locally is it worth taking the risk? art 12(2), Rome Convention (in EU) reflects most Western countries’ private international law rules the governing law of the receivable determines enforceability of assignment against the debtor and third parties better view appears to be that the same principle would apply to security over receivables

59. 58 Case study 2: defining the exit strategy Consequences of not perfecting locally independently of whether valid security has been created, the Insolvency Regulation treatment is also relevant: art 5 protection from main proceedings depends on having a “right in rem” unclear in the Insolvency regulation which law determines whether a right in rem has been created (art 2(g) strictly determines where the asset is for art 5 purposes, not which law governs the security or debt purchase) If a different country’s laws determine the validity of security/debt purchase, and there has been no local perfection in that country, there is a high risk that no right in rem has been created, hence no art 5 protection

60. 59 Case study 2: defining the exit strategy A note on bank accounts relevant when seeking security or other preferential rights over collection accounts in other countries: most straightforward bank deposits are classified, in most jurisdictions, as debts owed by the bank to its customer for Insolvency Regulation purposes, art 2(g) provides that a ‘claim’ is situated where the third party obligor has its COMI consider having collection accounts opened with the local branch of a bank whose own COMI is in an advantageous country example: Italian collections account could be held with a local branch of an Italian bank (account deemed to be in Italy under art 2(g)) or of an English bank (account deemed to be situated in England)

61. 60 Case study 2: defining the exit strategy To summarise each class of assets, and each separate company should be analysed: first, to ensure the creation of valid security (or debt purchase) independently of “COMI issues” second, to determine (or try to identify) COMI third, to identify any art 5 protections that could usefully be obtained: in countries where secondary proceedings are available in countries where secondary proceedings are not available fourth (if cost outweighs benefit) to create categories of ineligible asset or concentration limits fifth, to identify the correct reserves to be applied

62. 61 The checklist – a reminder The Checklist – a reminder Where’s COMI? What are the assets? Where are the assets? What insolvency laws will apply and how user-friendly are they? What’s the exit strategy?

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