CRR-opinions on credit protection
Under CRR Article 194(1)T, the lending institution must, upon the request of the competent authority, provide the most recent version of the independent, written, and reasoned legal opinion or opinions it used to establish whether its credit protection arrangement or arrangements meet the conditions on legal effectiveness and enforceability as outlined in the first sentence of CRR Article 194(1).
We are seeing growing interest from financial institutions and other financial undertakings for legal opinions on the legal effectiveness and enforcement of both unfinanced and financed credit protection arrangements in order to comply with CRR Article 194(1). In this context, financial institutions often also request confirmation that the relevant credit protection complies with the incorporation requirement set out in CRR Article 194 and Articles 201-215.
There are two types of credit protection:
- Funded credit protection
- Unfunded credit protection
In practice, funded credit protection typically consists of mortgages or pledges, whereas unfunded credit protection generally involves guarantees/sureties.
The CRR rules have been in place since 2013, but we are now seeing increased interest from Danish as well as foreign financial institutions in obtaining legal opinions on the compliance of credit protection arrangements with these requirements. Since several CRR requirements for credit protection can give rise to considerations when providing legal opinions and are not always identified at the time of the negotiation of the relevant agreements, we will outline some considerations that may be relevant already at the time of concluding the transaction documentation.
With respect to funded credit protection, this Insight focuses primarily on the assignment of receivables and chattel pledges, including stocks.
Unfunded credit protection
The primary examples of unfunded credit protection are guarantees or surety, typically issued by the Export and Investment Fund of Denmark (EIFO) (formerly EKF) or a foreign export credit agency.
Unfinanced credit protection is recognised only if granted by an eligible provider of credit protection under CRR Article 201. On 12 April 2023, the Danish Financial Supervisory Authority ruled that EIFO may be treated as a public sector entity as defined in CRR Article 4(1)(8), allowing exposures to EIFO to be risk-weighted at 0%, as specified in CRR Article 116(4). Additionally, KommuneKredit, Afviklingsformuen and Garantiformuen (special purpose credit institutions) are approved as public sector entities which also qualify for a 0% risk weighting.
Besides to requirements for eligible providers of unfunded credit protection, there are several conditions that the credit protection itself (the guarantee or surety) must meet, including the terms of the credit protection. According to CRR Article 213(1)(c) the credit protection contract must not contain any clause outside the direct control of the lender that:
- would allow the protection provider to cancel the credit protection unilaterally;
- would increase the effective cost of protection as a result of a deterioration in the credit quality of the protected exposure;
- could prevent the credit protection provider from being obliged to pay out in a timely manner in the event that the original obligor fails to make any payments due, or when the leasing contract has expired for the purposes of recognising guaranteed residual value, or
- could allow the maturity of the credit protection to be reduced by the credit protection provider.
In practice, the requirements concerning clauses outside the lender's control, particularly those allowing the guarantor or surety to cancel credit protection unilaterally or delay payouts, often raise questions when providing legal opinions under the CRR.
For instance, credit protection terms are sometimes drafted in a way that creates uncertainty about whether specific situations (e.g., the invalidity of an underlying commercial contract or the bankruptcy of a commercial party) give the provider a unilateral right to cancel the protection or if such situations are simply risks not covered by the protection.
The former is problematic under CRR Article 213(1)(c)(i), whereas the latter is acceptable as long as the lender has adjusted the value of the guarantee in accordance with CRR Article 215(1) when certain types of payments are excluded from the guarantee to reflect the limited coverage.
When negotiating guarantee terms, the lender should carefully assess whether the individual provisions pertain to default and the resulting right of termination or if they relate to the scope of the coverage. In the latter case, the uncovered risks should be reflected in the valuation of the credit protection.
Another common issue arises with respect to structures where the transaction documentation allows for more than one lender. In such case, the transaction documentation typically provides that a (potentially qualified) majority of the lenders may make decisions regarding amendments to the funding terms, the exercise (or waiver) of rights, etc. with binding effect on all lenders. These structures often involve an agent acting on behalf of the lenders, in accordance with the instructions of (a majority of) lenders.
In such cases, the credit protection agreement may include terms stating that certain acts or omissions by the agent or a lender constitute default under the risk protection agreement. As a result, the credit protection provider may be allowed to cancel the credit protection or suspend the pay outs under the credit protection, with binding effect on all lenders, including those who were not in default.
Given that the credit protection may potentially be discontinued due to actions that do directly involve a particular lender - and may even involve matters against which the lender voted - the inclusion of such terms can pose a significant risk under CRR Article 213.
Depending on the specific wording of these such terms, it is not clear whether they will be considered outside the direct control of the individual lender, raising doubts as to whether the requirements of CRR Article 213 are fully met.
To ensure compliance with the requirements of CRR Article 213, lenders should ensure that the agreement includes provisions allowing an individual lender to remedy any default by the agent or another lender. This would bring the ability to meet the terms of the agreement within the direct control of the individual lender.
Funded credit protection
Under CRR Article 194(4) a general requirement for funded credit protection is that the lender has the right to liquidate or retain, in a timely manner, the assets from which the protection derives in the event of default, insolvency, or bankruptcy of the obligor or, where applicable, the custodian holding the collateral, as set out in the transaction documentation.
The requirement implies that lenders who have appointed an agent to act on their behalf in relation to the collateral should ensure that the transaction documentation includes provisions allowing for replacement of the collateral agent in case of their default, insolvency, or bankruptcy. This ensures that lenders can still realise the collateral in a timely manner, even if the collateral agent becomes insolvent or defaults.
Additionally, under CRR Articles 295-212, various other requirements apply to funded credit protection, depending on the type of collateral involved.
Under CRR Article 209, special requirements apply to the assignment of receivables, which necessitate that the agreement for the assignment of receivables includes the following:
- the legal mechanism by which the collateral is provided must be robust and effective, ensuring that the lender has clear rights over the collateral, including the right to the proceeds from the sale of the collateral;
- local requirements regarding the enforceability of security interest must be fulfilled, with lenders having a first-priority claim over the collateral, although such claims may still be subject to the claims of preferential creditors, as provided for by legislative provisions;
- lenders must conduct a sufficient legal review confirming the enforceability of the collateral arrangements in all relevant jurisdictions;
- lenders must properly document their collateral arrangements and have clear and robust procedures in place for the timely collection of collateral;
- lenders must ensure that any legal conditions required for declaring the default of a borrower and for the timely collection of collateral are met;
- in the event of a borrower's financial distress or default, lenders must have the legal authority to sell or assign the receivables to other parties without the consent of the receivables obligor.
To obtain capital relief, lenders typically require confirmation of the above elements, except for those that pertain strictly to the lender's internal circumstances, in a legal opinion.
Regarding the requirement for the lender to have legal authority to sell or assign the receivables without the obligor's consent, this implies, in principle, a verification through a review of the terms of the assigned receivables. However, this may be impractical or unpredictable, particularly in the case of pledging future receivables.
In practice, lenders often mitigate this by ensuring that loan or collateral agreements include provisions stating that the receivables covered by the assignment are freely assignable and do not require the obligor's consent. The documentation should also obligate the lender to ensure that both existing and new receivables under the assignment can be freely assigned at any time.
Similar, under CRR Article 210, special requirements apply to chattel pledges. These include several requirements for the pledge agreement except for some claims related to the lender's internal circumstances and handling of the security. These provisions include:
- the agreement must be legally effective and enforceable in all relevant jurisdictions and must allow the lender to realise the collateral's value within a reasonable timeframe;
- with the exception of permissible first priority claims, only first liens shall qualify as eligible collateral, and the lender must have priority over all other lenders in relation to the proceeds of the collateral;
- the loan agreement must include detailed descriptions of the collateral as well as detailed descriptions of the manner and frequency of revaluation;
- the lender must have the right to physically inspect the collateral.
Lenders will typically seek confirmation of these requirements in a legal opinion. Particular attention should be given to the descriptions of the collateral, the process of valuation, and the right of inspection of the assets. Lenders should also ensure that the transaction documentation (such as the loan agreement) includes provisions for the continuous valuation of the collateral and the lender's right to physically inspect the collateral.
Recommendation
For lenders seeking capital relief on guarantees, surety, or pledges received in connection with a financing transaction, more thorough consideration is necessary. Both Danish and foreign financial institutions will benefit from addressing these aspects early in the financing process.
The requirements for obtaining capital relief for credit protection are complex and, as outlined above, involve uncertainties and potential ambiguities.
Therefore, we recommend that lenders assess the documentation from a CRR compliance perspective during the negotiation of the relevant financing agreements to ensure that the collateral qualifies as credit protection for the lender's risk-weighted exposures.
Additionally, lenders should ensure at the negotiation stage that all documents are prepared in a form that allows external counsel to provide the necessary legal opinion regarding CRR compliance.