In 2018, the German corporate lending market remained stable and active, with event-driven financings sparking activity despite the mergers and acquisitions markets falling short of their record highs in the previous years and slightly fewer opportunistic refinancings taking place.
The availability of debt capital across the various debt products generally continues to remain high and, as a result, German borrowers continue to benefit significantly from very borrower-friendly commercial and contractual conditions. Funding continues to be available for deals of any size and purpose, including multibillion-euro acquisition financings for large German corporates.
In addition to the syndicated loan market, the Schuldschein market (an established German version of a private placement with a long-standing history) has remained very liquid and active, with attractive commercial conditions for investment-grade borrowers, and – as in 2016 and 2017 – several jumbo issuances. Despite few first restructurings in relation to Schuldschein borrowers having occurred, Schuldschein loans continue to be available for non-investment grade borrowers and foreign issuers, but with an increasing focus on diligence and appropriate contractual terms. It remains to be seen whether Schuldschein lenders will ultimately start to refocus on investment-grade borrowers.
Debt-fund financings, including unitranches, have further stabilised their position in the German market. They have become a real second source for mid-market financings, especially for sponsor-driven deals.
In the syndicated lending market, the prevailing documentation standard is the Loan Market Association (LMA) standard. In fact, a dedicated German law-governed multi-currency facilities agreement LMA precedent for investment-grade borrowers exists. There is also a dedicated German law-governed real estate finance facility agreement for multi-property investment transactions.
In contrast, the Schuldschein market has, so far, not used harmonised documentation but in-house templates by the arranging banks, which at first glance may differ from arranger to arranger, but in substance are largely similar. Last year, the LMA published a template for Schuldschein loan documentation, which was developed together with several banks and law firms. It remains to be seen whether this LMA template will gradually replace the existing in-house documentation.
II LEGAL AND REGULATORY DEVELOPMENTS
Unlike many other jurisdictions, lending in Germany is generally a regulated activity that requires a banking licence under the German Banking Act if performed commercially or in a manner requiring a commercial business organisation. The licensing requirement applies irrespective of whether loans are granted to consumers or to non-consumers. According to the administrative practice of the German Federal Financial Services Supervisory Authority, the licensing requirement also applies to lenders domiciled abroad if they actively approach borrowers domiciled in Germany to grant loans. Not only the granting of a new loan but also the mere restructuring of a loan that has been acquired from the original lender (e.g., by extending maturity, adjusting interest rates) may qualify as lending activity requiring a banking licence.
The German Banking Act provides for certain exemptions from the requirement of a banking licence for lending business, in particular, for insurance companies granting loans as part of their activities permitted under German insurance regulation. Furthermore, portfolio management activities by German, EU or EEA undertakings for collective investments in transferable securities (UCITS), management companies and alternative investment fund managers (AIFMs) are not subject to the licensing requirement under the German Banking Act. Though UCITS are generally not allowed to invest in loans from an investment regulatory perspective, EU or EEA AIFMs may, depending on the laws of their home state, be allowed to originate loans for alternative investment funds (AIFs) they manage. As the origination of such loans for AIFs managed by an AIFM is part of the AIFM's portfolio management activities, an EU or EEA AIFM can extend such loans to borrowers domiciled in Germany without being exposed to licensing requirements under the German Banking Act. Fund managers and funds domiciled outside the European Economic Area only benefit from the exemption if the relevant fund may be marketed in Germany, which requires successful completion of a notification procedure. The relevant statutory provisions in this respect make clear that a mere notification for marketing to professional or semi-professional investors, which is easy in comparison with a notification for marketing to retail investors, is insufficient. In practice, this implies that the vast majority of non-EEA loan funds will still not be in a position to actively offer the extension or restructuring of loans to borrowers domiciled in Germany.
German funds remain subject to investment regulatory restrictions on lending. Except for special provisions applicable to shareholder loans, loans can generally only be originated by closed-ended German 'special funds' (i.e., funds restricted to professional or semi-professional investors, an investor category autonomously created by the German legislator). Loans to consumers are not permitted. A single loan may not account for more than 20 per cent of the fund's assets, and a German loan fund itself may only incur limited leverage (i.e., borrowing by the fund must not exceed 30 per cent of the fund's aggregate or committed capital). Fund managers managing loan funds are subject to additional organisational requirements on loan processing, which essentially replicate corresponding requirements applicable under German banking regulation to credit institutions.
Although the Basel III framework has largely been incorporated into German law because of the German implementation of the Capital Requirements Directive IV (CRD IV) and the Capital Requirements Regulation IV, which are directly applicable in Germany, banks still argue in credit agreement negotiations that they continue to be unable to factor the Basel III or CRD IV cost effects into their internal margin calculations. They, therefore, require borrowers to accept explicit carve-ins for the coverage of increased costs triggered by Basel III or CRD IV, even though the increased costs regime generally denies the coverage by the borrower if the legal framework already existed when the credit agreement was executed.
Huge penalties imposed on US and European banks in the United States for non-compliance with US sanctions and anti-corruption regimes have prompted many banks to put a lot more focus on ensuring compliance of their clients with these rules. In particular, US banks, but also other affected banks, are now requiring extensive representations and undertakings in credit agreements in that regard from their borrowers and related subsidiaries, including the requirement to comply with the US Department of Treasury's Office of Foreign Asset Control (OFAC) regulations, regardless of whether the relevant borrowers and their affiliates are in fact active in the US market. This extraterritorial reach of US regimes, in particular, of the sanctions regime, creates legal issues under domestic German law. German foreign trade law contains an anti-boycott rule that prohibits German individuals and corporations from participating in a boycott if it is not a sanction applied by Germany, the European Union or the United Nations. Though for most US sanctions there are similar sanctions in Germany, the European Union or the Unite Nations, Cuba, for example, is not sanctioned by these bodies. Were a German national to undertake to comply with US sanctions on Cuba (included in the OFAC regulations), it would be in breach of the German anti-boycott statute. The breach would constitute an offence. This issue was typically not only raised by the borrowers but also by certain German banks if they formed part of the syndicate, as there was fear that the offence committed by the borrower could also have an impact on the German lenders. While this German 'specialty', which has a European equivalent with the Blocking Statute – Council Regulation (EC) No. 2271/96 – which prohibits compliance by European persons with certain US legislation (including the sanctions against Cuba, Iran and Libya) as this may be prejudicial to EU interests – has been a topic for discussions for some years now, the market (including foreign banks) has recognised that the matter needs to be addressed properly. In recent credit agreements, the relevant representations and undertakings are usually qualified such that they do not apply if the relevant member of the borrower's group was otherwise in breach of applicable law. In addition, on the lenders' side, syndicate members can opt out from being addressees of the relevant representations and undertakings to ensure that they do not breach applicable law when requiring the borrower to give these representations and undertakings.
The latest trend in relation to these more specific 'compliance with laws' representations and undertakings that banks require from their clients is compliance with anti-money laundering (and also anti-corruption) provisions. The focus has shifted a little towards this topic as several banks have been, and continue to be, investigated for alleged breaches of anti-money laundering laws.
In 2017, the German Federal Supreme Court shook up the lending market in Germany with two different decisions: one in relation to upstream security and one in relation to upfront fees for loans in general business terms and conditions.
After many years of uncertainty, the Federal Supreme Court decided that, when determining whether the provision of upstream security would result in a breach of capital maintenance rules, the situation of the company at the time of the creation of the security (and not at the time of enforcement) had to be examined. The Federal Supreme Court went on to say that when at the creation of the upstream security a compensation claim by the subsidiary against its parent was fully valuable, capital maintenance rules would not be affected. Many market participants have read the decision in a way that means, going forward, typical limitation language (see Section IV) would no longer be necessary to ensure compliance with capital maintenance rules if the parent whose obligations are secured upstream was financially stable. However, certain other deliberations in the decision point to a much more conservative view and banks seem to have now largely accepted that borrowers require to continue to use limitation language in a similar manner as before the Federal Supreme Court decision, limiting enforcements to ensure compliance with capital maintenance at the time of enforcement.
In another ruling, the Federal Supreme Court held one-off upfront fees for loans invalid if agreed in general business conditions. As per the ruling, this does not only apply in relation to consumers but also to commercial undertakings. This ruling has unsettled market participants as typical upfront fees, such as arrangement and participating fees, which are desired by both banks and borrowers, could be at stake. Since that decision, both borrowers and lenders have regularly been collaborating to avoid or at least significantly reduce any invalidity risk using different methods, including the choice of foreign law for fee letters (which does not solve the problem in all circumstances), lenders offering alternative time-based remuneration elements to borrowers and borrowers proposing the upfront fees to the lenders when approaching the lenders. In contrast, the Federal Supreme Court has further confirmed its 2017 ruling with additional case law in relation to (invalid) upfront fees.
III TAX CONSIDERATIONS
For German tax-resident lenders, interest payments received under a loan are subject to corporate income tax, including solidarity surcharge thereon at an aggregate rate of 15.825 per cent plus trade tax (a tax levied by the different municipalities, which ranges from 7 per cent to approximately 18 per cent). Although Germany imposes a withholding tax of 26.375 per cent on certain categories of capital investment income, interest on ordinary loans is generally not subject to this withholding tax. Exceptions apply to hybrid loans (e.g., loans containing a profit participating component).
Lenders not tax-resident in Germany, in the absence of German withholding tax, are generally not subject to German taxes on interest payments made by German borrowers. There is, however, one important exception: if the loan is secured (directly or indirectly) by German-situs real estate, the foreign lender is required to file a tax return and pay taxes on the interest payments. To secure its tax claim in relation to foreign borrowers, German tax authorities can impose a respective withholding obligation on the borrower's interest payments. Most double tax treaties concluded with Germany, however, deny Germany the right to impose (withholding) taxes on such interest payments.
Typically, a customary German law loan document based on the LMA standard will contain standard LMA language (gross-up with the qualifying lender concept; tax indemnity provisions). Where the loan is secured by German-situs real estate, however, this language needs to be carefully rephrased to take care of the possible tax liability of a lender with respect to such interest payments and of the eventual withholding obligation of the borrower.
From a German tax perspective, interest payments are generally tax deductible (subject, however, to general interest deductibility limitations such as interest barrier rules). This also (and still) applies to interest payments on hybrid instruments where the lender's jurisdiction treats the 'interest' payment as a tax-exempt dividend, whereas Germany treats the same payment as a tax-deductible 'interest coupon'. Rather, these incongruences, as well as cases in which interest paid on a loan can be deducted in more than one jurisdiction, have become part of the European anti-tax avoidance directives that have been adopted by the European Union and are now to be implemented by the Member States. German governmental officials have announced that it should be expected that Germany will enact respective legislation in the course of 2019 while draft legislation has not been published yet.
Germany currently does not levy any stamp or documentary taxes on loan and security documentation, or loan trading documentation (neither upon execution nor enforcement).
As regards the Foreign Account Tax Compliance Act (FATCA), financial institutions in Germany do not need to enter into a FATCA agreement with the Inland Revenue Service, but rather have certain reporting requirements as regards the German tax authorities, and regular corporate borrowers should usually not be affected. Nevertheless, it has become market practice to include the LMA language on FATCA withholding into the standardised LMA loan agreements, whereby Rider 3 (FATCA is a lender risk) is typically used.
IV CREDIT SUPPORT AND SUBORDINATION
German law provides for several types of security interests. The main distinction is between accessory and non-accessory security interests.
Accessory security interests, such as pledges over receivables or shares, and mortgages over real estate, can only exist in conjunction with the secured claim or claims. In other words, they automatically lapse as soon as the secured claim is finally discharged or even exchanged. In addition, accessory security interests can be created for the benefit of the creditor of the secured claim only. Therefore, an accessory security interest cannot be transferred without simultaneously assigning the secured claim. This creates certain legal challenges for trading secured loans (see Section VI).
By contrast, the existence and validity of non-accessory security interests is legally independent from the existence of any secured claims. The link between the security interest and the secured claims is created by means of a security purpose agreement. For non-accessory security interests, agency structures do not pose any particular problems, and the secured claims can easily be exchanged. Generally, non-accessory security interests, such as assignments of receivables, security transfers of title to movables or land charges, are preferred over accessory security interests.
If more than one security interest has been created with respect to the same collateral, the earlier security interest would be senior in rank to the later security interest as a matter of law as far as pledges and land charges are concerned, or the later encumbrance would not be valid if the grantor no longer holds the title to the collateral, such as in the case of a prior assignment or transfer for security purposes. The order of priorities can be amended by contractual arrangement, which is commonly done through intercreditor agreements in the case of transactions involving various groups of secured creditors.
Apart from certain procedural constraints, enforcement of security is subject to a number of limitations. In the case of upstream or cross-stream security, enforcement against the assets of the security-granting subsidiary is usually limited to protect the security grantor's registered capital (based on a balance-sheet test) and sometimes also the liquidity of the security grantor, thereby shielding its management from potential personal liability, unless the loan proceeds have been made available to the security grantor ('limitation language', which will usually be addressed in German law legal opinions (see Section V)). For the statutory rules concerning the subordination of shareholder loans, see Section VII.
For certain security interests, the insolvency administrator may be entitled to control the enforcement process and retain a certain percentage of the enforcement proceeds for the benefit of the insolvency estate (haircut). German insolvency law also provides for a number of contestation rights that insolvency administrators frequently use to challenge transactions (including loan repayments or the creation of security) during certain suspect periods that can extend to up to 10 years prior to the filing for the opening of insolvency proceedings. German courts have given a very broad interpretation to a number of these contestation rights, and contestation rights have become a significant area of concern to lenders in any dealings with borrowers who experience – or might in the foreseeable future experience – economic difficulties.
V LEGAL RESERVATIONS AND OPINIONS PRACTICE
Legal opinions on German law-governed credit agreements contain various legal limitations or qualifications, some of which are similar to qualifications also made in other jurisdictions, such as limitations by applicable bankruptcy, insolvency, avoidance and other laws of general application to creditors, and principles of equity and good faith. Others are more specific to Germany and German law, such as the fact that longer-term agreements (such as credit agreements) may always be terminated for good cause, even if the contract provides that the agreement cannot be terminated during its agreed-upon term. German validity opinions will also mention that, under German law, any agreement to compound interest (and provisions having a similar result) will be held invalid by German courts.
More recently, the German Federal Court of Justice has held contractual clauses void that provide for an automatic termination of the contract or a right of the other party to terminate in the event of an insolvency of (or other insolvency-specific circumstances affecting) one party (insolvency-related termination clauses), unless these clauses correspond to specific statutory termination rights. Although this decision was rendered in connection with a long-term energy supply agreement, it is discussed and argued in legal literature whether this decision will also be applied to loan agreements and the typical 'insolvency' or 'insolvency process' events of default. Although there are good arguments why it should not, this matter will typically be addressed as a limitation in German validity and enforceability opinions, which will state that it cannot be ruled out that termination or draw-stop rights under a facility agreement cannot be validly exercised solely based on such insolvency-related termination clauses.
As regards the provision of guarantees and in rem security, German validity opinions will mention that the provision of guarantees or security by a German limited liability company, or a limited partnership with a limited liability company as general partner to secure obligations of its (direct or indirect) parent company and or any subsidiary of any of its direct or indirect parent (upstream or cross-stream guarantees and security), is subject to restrictions under German capital maintenance rules and under the doctrine of interferences jeopardising the subsidiary's existence. In addition, the legal opinion is likely to mention that it cannot be ruled out that the guarantee or collateral granted might be seen as to have been granted in violation of the liquidity protection rule set out in Section 64(3) of the German Limited Liability Companies Act if an enforcement of the guarantee or security would result in the illiquidity of the German subsidiary. As far as the guarantee and the security to be provided is concerned, the relevant agreements will customarily provide for limitation language (as referred to in Section IV), which aims at limiting the enforceable amount to what is permissible – in particular, under the capital maintenance rules – but the legal opinion will note that specific modifications to the calculation of the balance sheet test, as are customarily required by the lenders, may render the upstream guarantee and security to be in breach of capital maintenance requirements.
'Financial assistance' is not generally prohibited in Germany, but insofar as German stock corporations are the target of an acquisition, the stock corporation must not provide any direct or indirect support to the acquisition of its shares. This prohibition also applies to subsidiaries of stock corporations. Although the law explicitly states that financial assistance is not prohibited for a stock corporation if it is a controlled company under a domination and profit and loss pooling agreement (DPLA), legal opinions will contain a qualification that this should only apply if the loss equalisation claim that is the legal consequence of a DPLA is fully valuable.
Finally, in addition to the general qualifications in relation to insolvency laws, legal opinions will contain specific qualifications regarding clawback risk if collateral is granted in situations of financial distress, in particular in restructurings.
Legal opinions in German loan transactions are usually provided by both parties' counsels, with lenders' counsel usually providing the validity and enforceability legal opinion in relation to the credit agreement, the security documents and the intercreditor agreement (if any), and with borrower's counsel providing the capacity opinions for the borrower's side (i.e., borrower, guarantors and security providers).
All opinions are usually addressed to, and may only be relied upon by, the original parties on the lenders' side, namely original lenders, agents, mandated lead arrangers and book-runners. If the transaction is to be syndicated post-closing, the opinions are usually also addressed to, and may be relied upon by, the persons becoming lenders during the primary syndication of the credit agreement, provided that there is a long-stop date for the lenders becoming addressees (usually three or six months during which the primary syndication is usually completed).
Although the circle of addressees who are entitled to rely on legal opinions is limited, disclosure of legal opinions may also be made – on a strict non-reliance basis – to:
- any affiliates and advisers of the addressees to the extent they need to know the contents;
- any competent courts, or governmental, regulatory or supervisory authorities; and
- any potential (i.e., eligible) assignee, transferee or sub-participant so that the legal opinions may be made available for the purposes of loan trading.
Generally, courts in Germany will uphold the choice of foreign law governing a credit agreement and also enforce foreign court judgments. The recognition of the choice of law is subject to the German conflicts of law principles that would prevent the foreign law chosen from being recognised. Under these conflicts of law principles, the choice of foreign law would not be upheld to the extent, for example, that the result of the application would violate fundamental principles of German law, or be in conflict with internationally applicable overriding mandatory provisions of German or foreign law within the meaning of Article 9 of Council Regulation (EC) No. 593/2008 on the law applicable to contractual obligations. Or, if the relevant factual circumstances are only connected to a particular jurisdiction or jurisdictions of Member States of the European Union, German courts would apply the mandatory provisions of that jurisdiction or EU law irrespective of the choice of law of any other jurisdiction.
Any choice of law clause relating to non-contractual obligations, as is typically provided for in the governing law clause of LMA loan agreements, will be recognised and applied by the courts in Germany subject to Article 14 of the Council Regulation (EC) No. 864/2007, and subject to German public policy.
In the European context, a court decision rendered in an EU Member State will be recognised in Germany, and a court decision rendered in another Member State and enforceable in that Member State will be enforced in Germany without any declaration of enforceability by a German court being required. Each case is subject to the provisions of Regulation (EU) No. 1215/2012 of the European Parliament and of the Council of 12 December 2012 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters, and the provisions of the German Act on Civil Procedure.
A final judgment of a Swiss, Norwegian or Icelandic court for a finite sum of money will be recognised and enforced in Germany subject to the Convention dated 30 October 2007 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters (the Lugano Convention), as well as the applicable provisions of the German Act on Civil Procedure.
For court decisions from other non-EU Member States and states in which the Lugano Convention on enforcement does not apply, foreign court decisions are generally enforced following an action or suit brought in accordance with the rules of the German Act on Civil Procedure for an enforcement judgment. German courts will generally order an enforcement judgment without review of the merits of the foreign judgment. However, the German court would examine whether the foreign judgment is legally effective and final, whether there is any statutory or judicial impediment to enforcement, and whether there are any defences (within the meaning of German Act on Civil Procedure) that have arisen after the foreign judgment became legally effective and final. In particular, an enforcement judgment will not be rendered if:
- the courts of the state to which the foreign court belongs are not competent pursuant to German law;
- the defendant, who has not participated in the proceedings and raises this defence, has not been properly served the documents initiating the proceedings or not served in a timely manner so that it was in a position to defend itself;
- the judgment is inconsistent with a judgment rendered in Germany or with an earlier foreign judgment subject to recognition, or if the proceedings on which it is based are inconsistent with a proceeding in Germany that is currently pending;
- the recognition of the judgment would give rise to a result that is manifestly irreconcilable with basic principles of German law; or
- if in the jurisdiction of the relevant foreign court, a German judgment would not be recognised on generally equivalent conditions (reciprocity).
VI LOAN TRADING
In Germany, participations in loans are traded as in many other jurisdictions. In most cases, and certainly where the underlying loan agreements are documented under LMA standards, the secondary trading documentation is used based on the templates prepared by the LMA. In contrast to practice in the United Kingdom, a novation is normally not used as a method of transferring the participation of German law-governed loans, particularly if the loan is secured, as a novation would invalidate any pledges (or any other accessory security instruments) created under German law. This is because accessory security instruments are cancelled by operation of law if the secured claims cease to exist (see Section IV). In lieu of a novation, an assignment and transfer by way of an assumption of contract is used in Germany, which leads to a transfer of the contractual position as a whole, with all of its rights and obligations. In practice, the same result is achieved as with a novation. Besides this, ordinary assignments and sub-participations are also used as methods of transferring loan receivables (or the underlying risk).
Secondary purchasers can obtain the benefit of the security granted to the initial lenders in different ways, but typically in the syndicated lending market as follows.
As set out in Section IV, the key feature of securities under German law is the distinction between accessory security rights (dependent on the claim being secured) and non-accessory security rights (which remain in place even if the secured obligation ceases to exist). This distinction also plays an important role in the transfer of security if the loan is transferred. In addition, non-accessory security can be granted to a security agent by transferring to it the assets used as collateral. In syndicated loans, the non-accessory security will usually be held by a security agent and not transferred when a share in the loan is transferred. What is transferred is the claim against the security agent for a pro rata share in any proceeds from the enforcement of the non-accessory security. Accessory security, in contrast, depends on a secured claim and will transfer to an acquirer of a secured claim by operation of law once the secured claim is transferred. A pledge (and any other accessory security right) can only be created to the extent the pledgee is the creditor of the secured claim. This means that a security agent cannot receive accessory security in lieu of the lenders. The security agent can only receive a pledge that secures the obligations owed to it. Therefore, any pledge received by the security agent would not secure the claims of the (other) lenders. A particular problem arises in connection with accessory security if undrawn commitments are transferred, as the security cannot transfer to the purchaser in the wake of a secured claim. This is a particular issue for secured facilities in primary syndication as, at that time, the facilities are often still undrawn. Legal practice in the lending market has developed two 'solutions' to enable the security agent to also hold accessory security and to enable the transfer of shares in the facility agreement followed by an automatic transfer of security without a requirement for the security provider to regrant the pledge or pledges, even if the facilities are still undrawn: the parallel debt and the future pledgee concepts. Both concepts, although widely used in German secured lending, have not yet been confirmed by German courts as valid. In fact, it is doubtful whether they do operate as designed.
The security agent will usually be the only person entitled to enforce any security (the non-accessory security that is granted to it and the accessory security that is granted to the lenders), but the enforcement of this is usually delegated to the security agent by the lenders. In the documentation, lenders typically waive their right to enforce and individually delegate the exercise of that right to the security agent. As regards guarantees, this is much simpler. The guarantees are abstract (non-accessory) and made to any person who is a lender at the time the guarantee is drawn. Therefore, there is no transfer mechanism required or provided for. This is also one of the main reasons why loan agreements are secured by guarantees and not by the statutory German instrument suretyship, which is an accessory instrument.
VII OTHER ISSUES
Another issue to be considered by lenders in connection with German loan transactions is that, where lenders hold participations in a borrower (whether directly or indirectly) and those participations exceed 10 per cent of the (liable) share capital of the borrower, the loans granted by such lenders will, in insolvency, be subject to equitable subordination. In other words, they will be treated as shareholder loans and not rank pari passu with the other loan debt. Security created for equitably subordinated claims is not enforceable in an insolvency of the borrower. Also, in such situations, any payments received within the year before a filing for insolvency proceedings are subject to clawback by the insolvency administrator. Therefore, lenders who, either directly or through affiliated companies, are engaged in participating in companies should carefully note the shareholder structure of any borrowers they are lending to, to see if they or their affiliates might be invested in them.
VIII OUTLOOK AND CONCLUSIONS
The authors consider it likely that competition within and among the different debt products will continue for some time, and borrowers will make use of this beneficial market environment until the excess liquidity turns away from debt products or dries up.
1 Christian Schmies, Nikolaus Vieten and Jens Wenzel are partners at Hengeler Mueller, Partnerschaft von Rechtsanwälten mbB.