German Financial Institutions manage non-performing loans more and more by sales – bank secrecy and data protection are no barrier with regard to the sale
Although many legal aspects have to be observed within the course of the sale of distressed loans, there are no legal obstacles in Germany which would bar such sales. Since banks in the United States, in Asia and also in Italy have caused a sensation in the market by accomplishing sales of large portfolios of problem loans, this option has become increasingly attractive for German banks. German banks have accumulated a huge number of problem loans in their balance sheets in recent years. Numerous advantages are associated with the sale of such loans. Above all, the equity capital is credited and the balance sheet parameters are enhanced. Moreover, costs can be reduced to a great extent, particularly with regard to the collection of debts and by reorganisation of the audit proceedings which has to be conducted by banks with the aid of external auditors. In addition, space is created for relief or for reorientation of special "realisation departments". With increasing risk precaution the sale of loans may allow for extraordinary proceeds that have a positive influence on the overall annual result. This applies even if one takes great reductions from the face value into account.
Purchasers of portfolios of distressed loans are, for the most part, investment banks and private equity funds (associated with investment banks or independent). Most of these investors have gained experience in the High-Yield-Market and in the Asia crisis in recent years, where high margins have been achieved and are now looking for new markets. Funds and some banks refinance purchases of distressed loans or credit portfolios in general with their own assets. Investment banks are interested in integrating third parties by continuous placement or reorganisation of such credit portfolios, for example by means of Asset Backed Securities. The aim of the investors is diverse to all intents and purposes. Some are interested in the purchase of a high volume individual loan resulting from crisis cases as for example Holzmann or Flowtex, in order to make a trading profit. Others, so-called "Vulture Funds", use the purchase of liabilities of distressed companies to obtain control rights in order to liquidate the company or assume control at a later stage.
Value lies in the security
However, the purchase of a variety of problem loans from already existing portfolios gains more and more commercial importance. Many of these loans are secured by real estate or other rights. The security often constitutes the essential value of these portfolios. With the purchase of credit portfolios the collection, the collection of debts and the realisation of security by the purchaser or a third party, is generally transferred as well. Both the evaluation and determination of the purchase price, and the transfer of the collection of debts require the transmission of data protected by banking secrecy and data protection law. Since tendering procedures, at which many investors try to purchase the portfolio, precede most portfolio sales, this data is not only transferred to the purchaser but to several bidders. Banking secrecy and data protection law are often considered as obstacles to such transactions. Though both legal areas pursue different protection purposes – data protection law protects the private individual whereas banking secrecy protects the banking business – the legal criteria for an analysis are the same. Within the scope of an appreciation of interests of banking secrecy and the protection of certain personal information between the selling bank and the debtor, the commercial interests of the selling bank concerning the refinancing of the loans and the portfolio adjustment should take priority where distressed loans are concerned.
Data transfer is possible
Also, during the execution of the due diligence which precedes the sale, a transfer of protected data can take place. Though no case law does exists regarding the above described situation, one can anyhow assume that the legal situation is clear. In connection with the sale of companies it has been already acknowledged that information which is relevant for the purchaser can be disclosed if a purchase without this data is not feasible. This should also apply to the purchase of credit portfolios.
However, organisational arrangements should be made to ensure that – as far as possible – only data is used which has been made anonymous and the transfer of data is limited to the information which is necessary for the bidder. Additionally it is advisable to agree on special non-disclosure and confidentiality obligations.
However, bidders have to deal – within the scope of a due diligence – not only with portfolio data but also with legal aspects. With regard to loans secured by real estate, these include building and planning laws, lease problems if leases constitute the valuable characteristic of certain loans, and details of enforcement and collection law.
Unlike in Italy, where some high volume sales of distressed loans took place, the realisation periods in Germany are relatively short. However, the duration of procedures may vary significantly within different local court circuits. This is especially true if charges on real estate have to be realised. Investors who are interested in distressed loans generally aim at a liquidation of the portfolio within three to five years.
If the decision has been made to sell the problem loans, both the loans and the related security must be sold. In the purchase and transfer agreement concluded between the selling financial institution and the purchaser, the seller is generally liable for the existence of the receivables and the purchaser bears the complete loan risk. However, such agreements are often only concluded after long-lasting negotiations. In general, arrangements have to be made to prevent the sale of the credit portfolio from being evaluated as a transfer of business according to Section 613 a German Civil Code. This would lead to a transfer of employment relationships and thus to legal problems in the field of employment law.
Other problems which should be regulated in such an agreement concern the treatment of incoming payments or realisation proceeds between the close of the portfolio evaluation and the final transfer of the portfolio. In general the parties choose retroactively an effective date ("cut-off-date") as of which all proceeds and all costs are apportioned to the purchaser. Additionally, the transfer of the collection of debt or, alternatively, the management of the credit portfolio by the seller has to be contractually regulated. It is possible that the seller and the purchaser may plan to manage the loans together by a joint venture in order to optimise the management by using the complementary experience of both parties. Furthermore it should be ensured that the transfer of the related security is effected in a legally binding way. In particular, the transfer of charges on real estate causes enormous transaction costs. In general these costs are borne by the purchaser, who includes these costs within the scope of the price calculation.
No banking license is required
In cases where the collection of debts is transferred to the purchaser, aspects of banking supervision have to be observed. Often it is doubtful if the purchaser needs a banking license. Generally one can assume with regard to the management of distressed loans that the purchase, the collection of debts and the realisation of distressed loans do not constitute a banking transaction for which a license is needed. In individual cases, however, the demarcation indicating the existence of a banking transaction can be difficult and an accurate analysis of the future activity of the purchaser is advisable. In any case the transfer of the collection of debts to the purchaser requires a permit according to the law regulating legal advice (servicer or collection licence). When issuing the license the competent local court examines the professional qualifications of the collection company and of the person who will manage the collection.
In addition, the selling financial institution and the purchaser must inform themselves of the legal implications of a portfolio sale on the balance sheet and in relation to tax. A discharge of the loans from the balance sheet of the financial institution is effectuated if the risks connected with the portfolio, especially the credit risk, have been transferred to the purchaser. If the purchase price is lower than the book value of the receivable, the selling financial institution has to record an extraordinary deficit in the year in which the sale becomes effective.
An extension of such deficits over several accounting periods can be effected for instance in Italy and has motivated numerous financial institutions there to sell distressed loans. Such an extension is arguably not possible according to German law. On the other hand, financial institutions have as a matter of course the opportunity to record extraordinary proceeds if a portfolio is already largely amortised. A recent judgement of the European Court of Justice must be observed according to which the implications of credit sales with regard to sales tax and the transfer of the collection of debts within the scope of a factoring have to be analysed accurately. Although it is doubtful if the adjudication (judgement of the EuGH dated 26 June 2003, file number C 305/01) can be applied to this type of transaction, existing risks in this regard should be eliminated as far as possible by a corresponding transaction plan.
Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.
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