An investor may have financed part of a loan and yet lose the money already repaid by the borrower. All it takes is for the party that officially granted the loan to go into liquidation before transferring it to the investor.

It is this risk that Luxembourg wishes to eliminate. Introduced on 30 July, Bill 8813 would establish a specific regime for “cash sub-participations”, known on international markets as “funded sub-participations”. A&O Shearman sees this as a “major boost”, a significant catalyst for such transactions. The mechanism allows a bank, a financial sector professional or a debt fund to share the risk of a loan without transferring ownership of the debt.

The lender retains its relationship with the borrower. A participant finances part of the loan and, in return, receives the same proportion of the principal and interest repayments. This solution avoids a legal assignment of the loan. The government outlines the cost: “However, such a transfer results – for the lender – in the loss of the direct relationship with the borrower, and requires the transfer of the security associated with the loan to the transferee, a process that is often cumbersome, complex and costly.”

Sub-participation circumvents these difficulties. However, it exposes the participant to two types of default: that of the borrower and that of the lender acting as an intermediary between them. The explanatory memorandum acknowledges this: “As the lender remains contractually bound to the borrower and the participant has no rights against the borrower, the participant is therefore exposed not only to the risk of the borrower’s insolvency, but also to that of the lender.”

Legal protection

At present, unless security or other arrangements are in place, the participant may be treated as a mere unsecured creditor of the lender. The draft legislation radically alters this position. “The assets owed by the lender under the cash sub-participation agreement do not form part of his personal assets”, states Article 2. Repayments due to the participant would constitute a trust fund held in a fiduciary capacity. They could not be seized by the lender’s other creditors. Nor would their transfer be interrupted by insolvency proceedings.

That is where the “boost” lies. Participants would no longer need to assess only the quality of the loan and that of the lender: the cash flows due to them would be legally protected, which A&O Shearman regards as “the key practical development”.

Above all, the scheme has an international dimension. It would apply whenever the lender is based in Luxembourg, regardless of the law governing the agreement. A sub-participation documented under foreign law could thus benefit from Luxembourg’s protection. The scope of the scheme is also broad. The regime would not be restricted to credit institutions. It would cover any Luxembourg entity acting as a lender, in particular professionals in the financial sector and loan or debt funds.

Automatic cover unless waived

For new transactions, protection would be automatic, unless the parties decide to opt out. Existing contracts could expressly opt in. The draft thus makes the scheme easy to use without forcing parties to restructure their agreements.

This protection does not eliminate the borrower’s risk. Nor, under the current wording, does it require the use of a separate bank account. Lenders will therefore need to put in place adequate traceability measures to identify repayments and the share due to each participant. The treatment of internal bail-in also calls for some caution. The government considers that the liabilities in question may be excluded on the grounds of their fiduciary nature, but only if the conditions laid down in European law are met.

There is, however, no doubt about the overall ambition. According to the explanatory memorandum, the project is intended to “promote and consolidate the attractiveness of Luxembourg as a financial centre”, particularly in the secondary loan market, and to develop loan origination by Luxembourg-based lenders. A&O Shearman draws the following economic conclusion: “Overall, this bill represents a significant development for the Luxembourg financing market.”