The United Kingdom has decided to leave the European Union on March 29, 2019 (the “Brexit”). Given the current uncertainties how the Brexit will be structured, the discussion has arisen whether the choice of German law could be an alternative to choosing English law which has often been used in large leveraged financing transactions.
1. Summary
- The LMA’s German law standard loan documentation is already established in the market including for large syndicated financings.
- There is uncertainty post-Brexit whether courts in the Member States of the EU will continue to recognize the choice of English law in loan documentation in line with the existing European regulations and treaties.
- German law loan documentation does not differ much from English law loan documentation but there are a few particularities that lenders and borrowers need to be aware of. None of these particularities, however, affect the parties from agreeing on commercial terms of the relevant loan similar to those agreed in English law loan documentations.
- The German judicial system is fairly efficient with special chambers being competent for commercial disputes. As of January 2018 the courts in Frankfurt intend to enable the parties to conduct proceedings in the English language, too. Under EU regulations, jurisdiction clauses in favour of German courts will be given effect and German court judgements will still be automatically recognised and enforceable in other Member States.
- It is uncertain whether the Scheme of Arrangement will remain available in all circumstances but certain steps should be taken to ease the way to the benefits of a “Scheme”.
- The choice of German law does generally not affect the applicable insolvency regulation.
2. Choice of German law in Loan Agreements post-Brexit
Choice of German law – does it change so much?
There has always been a market for loan agreements governed by German law. In 2007, the Loan Market Association (“LMA”) published together with the leading German banks a standard documentation for the German loan market based on the LMA’s English law precedent. As a first step, the investment grade documentation was developed that has become the market standard in the German market. The German standard documentation is very close to the LMA’s English law precedent and also used for international syndication. Other precedents governed by German law developed by the LMA – such as a real estate finance precedent in the English and German language – followed. Since then, the German law governed precedents for the leveraged finance market (based on the English version but incorporating the German law specifics from the German law investment grade document) developed further and are currently already widely used in the mid cap and small cap segments. The German law investment grade precedent has also long been used for large capitalisation corporate lending and take-over financing transactions such as the acquisition financing of United Internet for the takeover of Drillisch.
How will a hard Brexit1 affect the choice of law in financing agreements?
Currently, choice of law arrangements are governed by the Rome I Regulation which, subject to certain limited exceptions, gives full effect to the parties’ choice of law in financing agreements2. In principle, the Rome I Regulation does not distinguish between the choice of the laws of a Member State and those of another jurisdiction (subject to one exception mentioned below).
Post-Brexit, the Rome I Regulation will continue to apply in the Member States and the laws (and therefore courts) of the Member States will recognise the parties’ agreement on the governing law, whether or not the country whose law is chosen is a Member State, in the same manner as they currently do. Whether similar rules will apply in the UK is currently unclear.
There is one further factor that has the potential to add uncertainty to the recognition of the choice of English law Post-Brexit. The Rome I Regulation provides for an exception to the parties’ freedom to select the governing law that may apply Post-Brexit in the event English law is selected by persons located in the Member States. If the transaction has no connection to England3 and the parties choose English law, then the mandatory laws of the EU (i.e., all EU regulations and the applicable national laws implementing EU directives, will apply notwithstanding the choice of English law). While most EU regulations and directives generally do not deal with contract law relevant for financing agreements, it will depend on the specifics of the relevant transaction whether and to what extent these laws may apply and the potential impact they may have on the terms of the financing agreements. This is clearly a disadvantage of choosing English law for financing agreements with maturity dates Post- Brexit.
3. Is it so much different?
No. As the commercial understanding between the parties remains the same regardless of the governing law chosen, the choice of German law will not result in material differences. While there are certain concepts under German law which either must be reflected in the loan documentation or must be complied with as a consequence of having chosen German law as governing law, none of these concepts will fundamentally intervene with the parties’ commercial agreement.
Freedom of contract is a general rule for contracts under German law and German law governed agreements are construed on the basis of the agreed wording. If such wording does not reflect (i) the common understanding of the parties or (ii) would lead to a result not intended by either party, the common understanding of the parties will prevail. The general principle of German contract law is that the intention of the parties should be considered, not merely the meaning of the wording chosen by the parties.
Terms known from contracts governed by English or New York law such as “best efforts”, or “in the ordinary course of business” are often used in contracts governed by German law that are held in the English language. It is recommended to agree explicitly on a German translation of these phrases or, at least, to agree explicitly that the contract shall be construed in accordance with German law to have a clear understanding on how these phrases should be read and construed.
In certain cases German law thrives to protect the contracting party against risks that the legislators deemed as particularly dangerous. These rules are particularly “borrower-friendly”.
- Capitalised interest
German law does not allow the parties to agree on automatic capitalisation of interest “upfront” upon entering into a contract. An agreement on automatic capitalisation of interest can only be completed retroactively for the interest payable but not yet paid or for capitalised interest, the amount of which is known to the debtor. Therefore, the payment of default interest on interest is provided by a payment of lump sum damages. Also, in subordinated financings where interest needs to be capitalised, ways around that rule are used in practice.
- Prepayment of loans at the end of the interest period
As it is market standard, revolving loans may always be repaid at the end of the interest period without a prepayment penalty being required. Term loans may also be prepaid without the prepayment penalty being paid at the end of the term for which the fixed interest has been agreed (i.e. floating rate loans at the end of each interest period) or if earlier, after ten (10) years. With a few exceptions not applying to non-public entities, these rules cannot be deviated from. These rules only apply to loan agreements but not to bonds. In practice, these rules do not play an important role as term loans exceeding a term of ten (10) years are very rare.
- Standard business terms
The rules on standard business terms (Allgemeine Geschäftsbedingungen) apply to all loan agreements, not only to consumer lending but also to loans taken out by enterprises, however, with a less restrictive standard. The aim of these rules is to protect the counterparty of those who are using their standard documentation against one-sided or unfair provisions. There is plenty of case law available on these rules.
First, the rules do not apply to clauses individually negotiated. Secondly, it has been accepted in the German market that the standard business terms rules may also apply to standard loan agreements and standard security documentations used by banks and that certain provisions may not work in the way as proposed by the lenders suggesting such documentation. The borrower or the relevant counterparty not suggesting the financing documentation is protected by these rules. If, as often seen in the market, the borrower proposes its standard documentation, these rules would apply to the borrower. However, given the case law precedents, there are very few rules which may not be effective as drafted if the agreement is proposed by the lender, such as setoff provisions, limitation of liability of the agent or fees for services that are for the benefit of the lender only. The
application of these rules may, of course, be avoided by way of negotiation. Other provisions that may be set aside do not play a very significant role in the commercial understanding amongst the parties or are easily fixed by appropriate drafting if not individually negotiated. If the borrower prepares the agreement, those rules are largely irrelevant in practice as typical loan agreements do not include clauses unfairly treating the lender.
- Trust structures
German law does not recognise the concept of a common law trust. This concept is replaced by using a German law trustee (Treuhänder) acting on behalf of the lenders. The security agent holds the transaction security in its capacity as Treuhänder.
The provision on granting and holding security will not change when choosing German law as the governing law as the granting of the security has always been subject to the laws of the jurisdiction where the relevant security is located.
- Bail-in provisions
According to Article 55 of the EU Bank Resolution and Recovery Directive (BRRD) provisions for certain “bail-in powers” of the regulators of EEA must be agreed upon in a loan document which is not governed by the laws of a non-EU member state. After the Brexit, an English law loan agreement, as is already the case for
e.g. New York law governed loan agreements, bail-in provisions need to be agreed upon if an EEA financial institution is party to such loan agreement. If German law is chosen as the governing law of the financing documentation, no bail-in provisions are required.
- Licensing requirements
The lenders will not require a banking license in Germany only as a consequence of choosing German law. As a general rule, lending business is a regulated activity in Germany and can only be conducted by licensed banks, insurers and certain types of qualified debt funds. Banks licensed in the EU can lend to German borrowers under the so-called EU passport. The license is required regardless of the laws governing the financing documentation, i.e. loans granted to German borrowers do also require a license, if they are governed by English or US law.
- Sanctions
Similarly, the German rules on sanctions are not affected by the laws chosen to govern the financing documentation.
4. Jurisdiction and recognition and enforcement of judgments – how will a hard Brexit affect them?
- The legal system
Germany has the benefit of a functioning legal system with specialised chambers of commerce dealing with commercial matters. The Frankfurt courts have recently announced that the English language will be recognised as a language of court for specific commercial chambers at the Frankfurt courts as of January 2018.
- Which court to choose?
There are obvious benefits in having a court familiar with the governing law hearing the case. Strictly speaking, the jurisdiction of the courts to which the parties wish to submit need not be the same as the jurisdiction of the governing law of the contract. When choosing German law as governing law, it is recommendable to choose Germany as the place of jurisdiction. It is therefore established practice in financing transactions in the European market that submission to jurisdiction and choice of law are consistent.
- Recognition of judgments
The recognition and enforcement of judgments in the EU are currently regulated by the Brussels Ia Regulation. The Brussels Ia Regulation provides for the automatic recognition and enforceability of judgments of the courts of one Member State (i.e., Germany) in other Member States. This harmonisation is generally viewed as a substantial achievement by the EU as it ensures certainty and efficacy of recognition and enforcement of judgments throughout the EU and minimises the need for multiple litigations and the risk of divergent judgments in Member States.
Post-Brexit, the legal situation will remain the same within the EU (i.e., jurisdiction clauses in favour of German courts will be given effect and German court judgements will still be automatically recognised and enforceable in other Member States). However, the Brussels Ia Regulation will no longer apply to the submission to the jurisdiction of English courts by a person located in a Member State and to the recognition and enforcement of judgments of an English court. The courts in the Member States reviewing jurisdiction clauses for the benefit of English courts or requested to recognise and enforce judgments by English courts will have to apply their local civil procedural law when determining the validity of the submission to the jurisdiction of English courts and the requirements for recognition and enforcement of English judgments. Those local laws and requirements vary from Member State to Member State and often the existence of bilateral treaties between the two states concerned will determine if and to what extent judgments by the courts of one country will be recognised and enforced in the other country and the procedural requirements therefor. Post-Brexit this may have the undesirable effect that in certain Member States jurisdiction clauses will be recognised, and English court judgments will be recognised, and in case of judgments be enforceable, in certain Member States but not in other Member States. Even in Member States where English judgments are generally recognised and enforceable, at the very least a certain delay in the recognition and enforcement of English judgments in Member States will have to be taken into account.
Should the parties nonetheless wish to submit to the exclusive jurisdiction of the English courts, an in-depth analysis of the procedural laws and bilateral treaties of the jurisdictions in which recognition or enforcement of the judgment may be sought will be necessary, in particular in the jurisdiction of the borrowers or guarantors or the jurisdiction relevant for the enforcement of security. Financings for a group of companies incorporated in various Member States will therefore require additional lengthy and cumbersome legal analysis if the courts of a non-Member State are granted exclusive jurisdiction.
This problem may be avoided by providing for non-exclusive (or one-sided exclusive) jurisdiction clauses4. Those clauses would enable the finance parties to sue the obligors in their relevant home jurisdiction, but the downside would be an undesirable split of the jurisdiction of the governing law and the jurisdiction of the courts hearing the case.
- Scheme of Arrangement
The Scheme of Arrangement has become a popular instrument also for non-English companies to overcome the unanimity requirements in facilities agreements and other financing agreements. Companies that wish to avail themselves of the benefits of a Scheme of Arrangement must pass the “sufficient connection” test. English courts consider, among others, English law as governing law of the obligations proposed to be subject to the Scheme of Arrangement as sufficient to pass this test. Should a law other than English law be the governing law of the relevant financing agreement, the sufficient connection must be established otherwise, which may be difficult in practice depending on the specific facts of the case.
In order to be able to utilize the Scheme of Arrangement in those circumstances, the governing law of the financing agreement may have to be changed from the originally governing law to English law if there was no other “sufficient connection”. Whether or not this is feasible will depend on the unanimity requirements in the relevant financing agreements, and care should be taken by the parties and their advisers not to leave this issue to interpretation, but rather to expressly deal with this scenario, e.g. by stating that a change to English law only requires the consent of the majority lenders (or noteholders). A change of the governing law to English law in order to pass the “sufficient connection” test has been accepted by the English courts before, but there is no certainty that they will continue to do so.
However, even if this hurdle is overcome, the cessation of the application of the Brussels Ia Regulation to judgments and other decisions by the English courts (see no. IV) may create significant uncertainties for the recognition of the Scheme of Arrangement for non-English companies. An English court will generally sanction a Scheme of Arrangement only if it (and its effects) will be recognised in the jurisdiction of the obligor(s) whose obligations are being “schemed”. As set out above, recognition of judgments of the courts of non-Member States in the Member States Post-Brexit depends on the procedural laws of the relevant Member State, and whether the English courts will be comfortable that the Scheme of Arrangement will be recognised in such jurisdiction(s) is therefore uncertain, not least because the Scheme of Arrangement may not even be a “judgment” within the meaning of local procedural laws regulating the recognition of decisions of foreign courts. Should the Scheme of Arrangement Post-Brexit be considered as an insolvency proceeding from an EU perspective (rather than a judgment) it would only be recognised in the Member States if the centre of main interest (COMI) of the debtor was located in the UK.
Finally, it is being discussed whether the effects of the Scheme of Arrangement may be recognised by virtue of the Rome I Regulation (as the operation and effect of English law on the obligations subject to the Scheme of Arrangement should be recognised by the courts of Member States). However, this is controversial and has not yet been confirmed by the courts and in any event would provide less comfort than an automatic recognition of the decision.
Should the proposal by the EU Commission for a directive on preventive restructuring frameworks, which permits a cram-down of minority creditors, be adopted, the importance of the Scheme of Arrangement for companies located in the EU will diminish anyway.
5. Insolvencies – are they affected by the choice of German law and jurisdiction clauses in favour of German courts?
Under the European Insolvency Regulation (“EIR”), the order by a court of a Member State for the opening of insolvency proceedings shall (automatically) be recognised in the other Member States without any review, whether or not the court was competent for the opening of insolvency proceedings. Post-Brexit, the EIR will no longer apply to insolvency proceedings opened by English courts and therefore such insolvency proceedings would only be recognised on the basis of the respective national laws of the Member States.
The choice of German law in financing agreements has typically no impact on the question which court is actually competent for the opening of insolvency proceedings and whether or not such insolvency proceedings will be recognised in other states. Under the EIR the courts of the state in the territory where the debtor’s centre of main interests (COMI) is located shall have jurisdiction to open insolvency proceedings, and the COMI of a debtor is determined on the basis of various circumstances and indications, such as the place of the management and the location of relevant premises and workforces, but generally not the governing law of its (financing) agreements Therefore, the choice of German law in (financing) agreements as such would generally not lead to the assumption that the COMI of the respective company is situated in Germany.
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