Two recent laws have attracted the attention of the legal and
financial community in Luxembourg and abroad. One is the law of
July 27 2003, which approves the Hague Convention on the law
applicable to trusts and their recognition and regulates fiduciary
contracts. The other is the much-anticipated law on securitization
of March 22 2004.
The law on trusts and fiduciary contracts
The Law of July 27 2003 (the 2003 Law) is of considerable
practical interest and pursues various purposes. Firstly, it
ratifies the Hague Convention on the Law Applicable to Trusts and
on their Recognition (the Hague Convention). Secondly, it is
intended to enhance the recognition of fiduciary contracts,
previously governed by the Grand-Ducal Regulation of July 19 1983
and to broaden its scope by extending the categories of operators
that qualify as a fiduciary.
Ratification of the Hague Convention
The conflict-of-law rules laid out in the Hague Convention prove
useful for civil law countries, most of which have neither
substantive rules nor conflict-of-law rules on trusts in their
legal system.
The absence of a clear framework on how to assimilate a foreign
trust had a particular impact on securitizations carried out by
Luxembourg vehicles because the legal documentation, usually
governed by English law, makes ample use of the trust. It normally
provides for the noteholders to be represented by a trustee, who
often also acts as security trustee, holding and enforcing security
granted by the securitization vehicle for the benefit of the
creditors of the vehicle. Although there was some fragmented
Luxembourg case law on the question of the recognition of trusts,
which gave effect, in certain circumstances, to trusts, some doubts
remained and a recharacterization of a trust by a Luxembourg court
could not be ruled out.
In this respect, the 2003 Law represents a significant
improvement, because a trust created in accordance with the law
specified by the conflict-of-law rules of the Hague Convention must
be recognized as such. As a principle, Luxembourg courts have to
apply the substantive law of another country to trusts expressly or
implicitly stated to be subject to the laws of that country, or,
where no applicable law has been chosen, the substantive law of the
country with which the trust is most closely connected.
The concept of trust has no equivalent under Luxembourg Law and
it is not possible to introduce such a right in rem in the
Luxembourg legal system, so the 2003 Law expressly determines the
effects of a trust covering assets in Luxembourg. The rights and
obligations of a trustee are determined by reference to those of an
outright owner. This analogy does not prejudice the principle of
separation of the estate formed of the trust assets from the
personal estate of the trustee.
Fiduciary contracts
The 2003 Law defines a fiduciary contract as any contract by
which a person, the fiduciant, contracts with another person, the
fiduciary, whereby the fiduciary, subject to the conditions laid
down by the parties, becomes the owner of the fiduciary assets.
As was stated above, fiduciary contracts were previously
governed by a Grand-Ducal Regulation of 1983 (the Regulation),
which created a highly flexible instrument that could be used for
purposes as varied as wealth management, security and liberalities.
It also served as a structured finance tool. In one of the more
commonly used structures, a bank, acting as fiduciary, would issue
fiduciary notes that incorporated a fiduciary agreement between the
bank and each noteholder. The fiduciary agreement would set out how
the fiduciary was to invest the proceeds of the note issue. The
assets purchased by the fiduciary and any income received would be
transferred to the noteholders, whose recourse against the
fiduciary was limited to such assets. The proceeds and the assets
acquired with the proceeds by the fiduciary together with any
income generated by these assets would be segregated from the
personal assets of the fiduciary by virtue of the Regulation, and
this segregation would survive even in case of bankruptcy of the
fiduciary. These transactions had no affect on the bank's
regulatory capital because they were recorded off balance
sheet.
The 2003 Law, while repealing the Regulation, reinstated all its
attractive features and substantially enlarged the scope of
entities that can act as fiduciary. They are, in addition to banks,
investment enterprises, investment companies of fixed or variable
capital, securitization companies, fund management companies,
pension funds, insurance or re-insurance enterprises or national
and international public organizations operating in the financial
sector, whether they are in Luxembourg or abroad.
Under the Regulation, the definition of fiduciary contracts did
not correspond to the criteria of trusts contained into the Hague
Convention, the scope of which includes not only trusts of common
law countries but also institutions of civil law countries, whether
these are patterned on the trusts of common law countries or
otherwise bear the essential traits of trusts. The 2003 Law
modified the definition and effects of fiduciary contracts to
ensure compliance with the criteria set out in the Hague
Convention. As a result, contracting states of the Hague Convention
are bound to recognize fiduciary contracts entered into under
Luxembourg law and must apply the substantive law related to
it.
The law on securitization
The first securitization transactions were carried out in
Luxembourg in the early nineties. The country has since gained a
reputation as one of the main international centres for
securitizations due to a large extent to an unobtrusive regulatory
environment and a stable tax framework.
However, unlike countries such as France or Belgium, Luxembourg
did not have specific legislation on securitization. In a bid to
modernize the laws on the financial sector in Luxembourg, and
mindful that the absence of a dedicated legal background created a
few grey areas that were likely to hamper the development of the
securitization sector in Luxembourg, the new law was passed on
March 22 2004 (the 2004 Law). The 2004 Law is a comprehensive text
that spans all aspects of law that impact on securitization:
company law, contract law, security law, bankruptcy law and tax
law.
It has been designed to meet the expectations of the market by
creating a dedicated yet flexible legal environment in which the
market actors are able to pick and choose the features they want to
apply to each individual structure. Existing transactions will not
be affected unless the securitization vehicle expressly chooses to
place itself under the 2004 Law. Likewise, the application of the
2004 Law to new transactions is elective. Only if a securitization
vehicle issues notes to the public on a continuous basis (the
condition of the continuous issuance and the condition of
issuing to the public being cumulative) will it have to
place itself under the 2004 Law and be licensed and supervised by
the Commission de Surveillance du Secteur Financier (CSSF), the
regulator of the Luxembourg financial sector. It should be stressed
that neither the conditions for obtaining a licence nor the ongoing
supervision by the CSSF are onerous and any properly organized
securitization vehicle that issues notes to the public on a
continuous basis should be able to meet the legal requirements for
obtaining a licence and conducting its activity as a licensed
securitization vehicle.
Securitizable risks
The benefit of the 2004 Law will be available to all types of
securitizations. Indeed, one of the merits of the 2004 Law, which
differentiates it from legislation adopted elsewhere, is its broad
scope. Securitization is envisaged as the transfer of a risk rather
than the mere transfer of a monetary claim or asset. The
securitizable risk may be attached to assets of any nature, to
obligations of third parties, or to the activities of third parties
regardless of the way in which the vehicle bears such risk (true
sale, guarantee, swap, or any form of contractual obligation).
Conventional securitizations, and also more recent forms of
securitizations such as synthetic securitizations or whole business
securitizations, fall squarely under the 2004 Law.
The 2004 Law introduces a host of provisions aimed at
facilitating the transfer of risks to the securitization vehicle
and dispelling uncertainties related to it. Here are but a few
examples:
The 2004 Law sets out that the assignment of receivables is
valid between the assignor and the assignee and enforceable
vis-à-vis third parties by the mere agreement between the
assignor and the assignee, that is, without notification to the
third parties. Their protection is guaranteed by the possibility to
discharge their obligation against the assignor, which from a
practical point of view should not be detrimental to the assignee
that often appoints the assignor to act as its servicer.
It also validates the true-sale character of a transfer of
receivables where such receivables, subsequent to their assignment
to the securitization vehicle, are transferred to a third party or
even the initial assignor (which is often the case when credit
enhancement is obtained by an over-collateralization). The 2004 Law
excludes the re-characterization of such transactions, for example
as secured indebtedness of the initial assignor.
Finally, the 2004 Law clarifies the question of the
enforceability of the assignment of receivables against third
parties other than the assigned debtor (as this situation is not
foreseen in the Rome Convention on Law Applicable to Contractual
Obligations) and states that it is governed by the law of the state
where the assignor is situated. This provision is in line with the
UN Convention on the Assignment of Receivables in International
Trade signed in New York in 2001 and may well become a more
generally accepted conflict-of-laws rule.
In Luxembourg, and elsewhere, synthetic securitization and the
transfer of credit risks by means of credit derivates have caused
some concern as to whether they constitute a form of credit
insurance, which would require that the seller of insurance obtain
a licence. The 2004 Law expressly excludes securitization
transactions from the realm of the Luxembourg law of December 6
1991 governing the insurance sector.
Securitization vehicles
The 2004 Law proposes two forms of securitization vehicles. One
is a special purpose company, the other a securitization fund
managed by a management company.
The securitization company
The securitization company may be set up exactly as was done
before the 2004 Law, but the company may now elect to place itself
under the 2004 Law.
It may be subdivided into autonomous compartments. The 2004 Law
also allows a dissociation of the acquisition and issuing
functions, which can be performed by different entities. It is
therefore possible to reach outstanding levels of customization in
the design of securitization structures depending on the
characteristics of each project and on the desired risk-allocation
pattern.
The distinctive feature of the securitization company compared
with the securitization fund is that the former has full legal and
tax personality. It remains subject to regular corporate income tax
on any profit it may realize. Consequently, the securitization
company is fully entitled to tax treaty benefits, which is
sometimes an essential feature of the securitization structure.
Securitization companies are exempt from net worth tax. Like
securitization funds, they bear a fixed capital contribution duty
(maximum €1,250 ($1,509)) instead of the regular 1% duty, and their
management by an external management company is not subject to
VAT.
As a matter of principle, there is no withholding tax (WHT) in
Luxembourg on payments of all items of income from capital other
than dividends. In particular, Luxembourg does not apply any WHT on
interest paid by one of its residents to either a resident or a
non-resident. The WHT exemption also covers dividend payments made
by securitization companies on shares. Shares and bonds issued by
securitization companies are exempt from any duty.
Securitization funds
The securitization vehicle may also take the form of a
securitization fund, managed by a management company. Although the
fund has no legal personality, the participants' liabilities are
limited by law to the amount of their participation. Securitization
funds are of an exclusively contractual nature. The fund can be
structured through a Luxembourg law fiduciary agreement, under
which its assets will be held by a fiduciary. Alternatively, simple
co-ownership of the fund's assets by the investors is also
possible.
Each fund has a set of management regulations. If the fund has
compartments, it is possible to specify a different set of
management regulations for each compartment.
The fund has to be managed by a management company, acting in
the exclusive interest of the fund and the investors.
Unlike securitization companies, securitization funds fall under
the tax regime applicable to investment funds. This results in
securitization funds being exempt from all direct taxes. The only
difference with investment funds is that securitization funds are
not subject to subscription tax (taxe d'abonnement). They
only have to bear a capital contribution duty (maximum €1,250).
There is no withholding tax on distributions made by the fund.
Tax consequences will arise exclusively in the hands of the
beneficiaries of distributions by the fund.
The management of Luxembourg securitization funds is exempt from
VAT, that is, no VAT will apply on management fees paid.
Bankruptcy remoteness
Luxembourg securitization vehicles are insulated from bankruptcy
to the greatest extent possible:
The rights of investors and creditors are limited to the assets
of the securitization vehicle. If the securitization vehicle has
created several compartments, the assets of each compartment are
exclusively available to satisfy the claims of the investors who
funded them and of the creditors whose claims arose in connection
with these assets. So far, this so-called limited recourse has been
established on a contractual basis, but in the absence of any
express legal rule and court precedents on this matter, its
enforceability could not be guaranteed. It is now anchored in the
2004 Law. This recognition was awaited by securitization
professionals, especially rating agencies, because limited recourse
is essential in ensuring the bankruptcy remoteness of
securitization vehicles, especially when they issue multiple series
of notes, for example in the context of a programme.
Following the same idea, the 2004 Law also confirms the
possibility for a securitization vehicle to issue several tranches
of securities corresponding to different collateral and providing
for different value, yield and redemption conditions.
Subordination provisions between the securitization vehicle and
its creditors whereby the creditors establish a ranking of their
respective claims and so-called no-petition provisions whereby the
creditors agree not to petition for the bankruptcy of the
securitization vehicle are commonly found in securitization
transaction documents. Until now there was some doubt as to their
validity and enforceability. The 2004 Law expressly confirms the
effectiveness of these clauses.
Trustee based in Luxembourg
The 2004 Law creates a legal framework for trustees
(représentants-fiduciaires) based in Luxembourg.
A trustee may be included in a securitization structure at the
investors' request or pursuant to the articles of incorporation or
management regulations of the vehicle.
The powers of the trustee are defined by the investors or by the
securitization vehicle, depending on the issues raised.
The trustee can act in the name and on behalf of the investors -
the representative function, or in its name and on its behalf but
in the interest of the investors - the fiduciary function. The
investors can transfer on a fiduciary basis the ownership of the
assets and rights they hold and any security in relation those
rights to the trustee. In its capacity as fiduciary, the trustee
can receive payments that are owed to the investors with
discharging effect and enforce the security granted to the
investors.
Author biographies
Alex Schmitt
Bonn Schmitt
Steichen
Alex Schmitt was born in Luxembourg. He was admitted to the Bar
in Brussels in 1979 and in Luxembourg in 1983. He received his Lic
Jur. from the University of Brussels in 1978; his Lic Droit
Européen in 1980 from the Institute of European Studies, Brussels;
and his LLM from Harvard Law School in 1981.
He is a member of CODOJU (consultative body to the prime
minister of Luxembourg on the improvement of the financial centre's
legislative framework) and the Committee on Undertakings for
Collective Investment with the Supervisory Authority of the
Financial Sector (UCI Committee - Comité OPC). He is also a
lecturer at the University of Brussels Law School, a lecturer in
tax law at the Institut de Formation Bancaire, Luxembourg, and a
visiting lecturer in taxation at the Université of Bourgogne,
Dijon, France, and ICHEC, Brussels, Belgium. He is a member of the
International Fiscal Association and of the panel of Conciliators
and Arbitrators of the International Centre for the Settlement of
Investment Disputes in Washington DC, as well as an arbitrator at
the Permanent Court of Arbitration, The Hague, Netherlands.
His principal practice areas are banking and financial law,
securities law and regulation and mergers and acquisitions. He
speaks English, French, German and Italian.
Laurent Lazard
Bonn Schmitt
Steichen
Laurent Lazard was born in Luxembourg. He was admitted to the
Luxembourg Bar in 1990. He received his Maîtrise en Droit des
Affaires in 1989 and his DESS en Droit des Affaires et Fiscalité
des Entreprises in 1990, both from the University of Paris II. He
received his LLM from the University of Chicago Law School in
1993.
His principal practice areas are banking and financial law,
structured finance and securities law and regulation. He speaks
English, French and German.
Bonn Schmitt Steichen
44 Rue de la Vallee
L 2015
Luxembourg
Tel: +352 45 5858
Fax: +352 455859
Web: www.bsslaw.net