Luxembourg: Due Diligence Of Luxembourg Target Companies

M&A transactions regularly involve the acquisition of Luxembourg target companies.

The target may have operations based in Luxembourg. We are seeing, for example, a significant amount of consolidation in the Luxembourg financial sector.

It is fair to say, however, that the majority of Luxembourg target vehicles are holding companies. Luxembourg continues to be a popular jurisdiction for holding company structures, and a share deal at the level of the "LuxCo" is often the preferred means of exit. These companies hold a wide variety of investments across a range of sectors and geographies, but many of the issues that arise in respect of their due diligence are recurring and apply irrespective of the sector.

This article provides a brief introduction to the legal context in which due diligence exercises are carried out, a summary of the principal sources of information that are available to buyers of Luxembourg companies and an overview of some of the issues that frequently arise.

Why Carry Out Due Diligence?

Shaping the deal structure

The results of the due diligence exercise will shape the deal structure and its terms. On a share deal and in the case of a merger, demerger or other form of universal transfer of assets, all of the liabilities and risks in the target will transfer. A buyer may be reluctant to entertain such a deal, or may require a reduction in price, in the event that the due diligence exercise unveils significant or potentially significant liabilities or risks. A pre-closing reorganisation or carve-out of out-of-scope assets and liabilities may be required. A sale of specific assets may be preferable.

Limited protection from the general law

In our experience an increasing number of sale and purchase agreements ("SPAs") relating to Luxembourg target companies are governed by Luxembourg law. Luxembourg law is sometimes seen as the neutral choice between buyers and sellers from different jurisdictions.

Under an SPA governed by Luxembourg law, absent fraud, breach of the general duty of good faith and other extreme circumstances, the buyer will obtain very little automatic protection from the general law. That protection is likely to be limited to the existence of the shares and the ability to use them for the purpose for which they were acquired (i.e. the ability to exercise the economic and voting rights which are attached to them), and is unlikely to extend to the quality or value of the target company itself. On a sale of assets, the Luxembourg civil code may offer more protection depending on the nature of the assets and, potentially, the nature of the contracting parties.

In the event that the SPA is governed by English law, the general principle is one of caveat emptor or "buyer beware". In other words, the buyer will be responsible for assessing the nature and value of what it is acquiring.

A combination of effective due diligence and targeted buy-side protection under the SPA is essential.

Varying levels of protection under the SPA

"Market practice" as it applies to the terms of an SPA governing the sale of a Luxembourg target often reflects the nature of Luxembourg as a hub for international investment structuring.

Both the seller and the buyer are likely to want to impose their own idea of what "market practice" is, where it suits them to do so. Practice will often be driven by the jurisdiction in which the underlying assets are located. A sale of a Luxembourg company which holds German real estate, for example, may adopt German market practice with respect to the terms of the SPA, even if the SPA itself is governed by Luxembourg law. A number of trends that apply consistently across continental Europe (but which may be unfamiliar with US or Asian buyers) will often be relevant – for example the increasing but still relatively infrequent (in our experience) use of a "material adverse change" condition. A certain amount of domestic Luxembourg practice has also developed, particularly in certain sectors such as reinsurance.

Where the acquisition forms part of a competitive sale process, there may be commercial pressure to limit warranties and other forms of buy-side protection to the minimum.

Where the target is held by a private equity seller, (and while we have seen some interesting recent trends here), it may not be possible to obtain any meaningful business warranties at all.

All of this means that the SPA, including the extent of buy-side protection for liabilities and risks in the target, and the limitations on the seller's liability for related claims, is unlikely to be perfect from the buyer's perspective. It may for example provide for general disclosure of the data room, a relatively low aggregate seller's liability cap and/or a true "deductible" in relation to the de minimis or "basket" limitations.

Effective buy-side due diligence is therefore a must.

Sources Of Information

Luxembourg companies registry

The extent to which information is publicly available on a Luxembourg target company will depend on its legal form.

In relation to a private limited liability company or "S.à r.l.", by far the most common form of Luxembourg company, an online search will reveal the identity of its shareholder(s) and members of its board. As the name suggests, an online search in relation to an "S.A." or société anonyme, the second most common form of Luxembourg company, will generally not reveal the identity of the current shareholder(s).

Articles of association, annual accounts, notarial deeds varying share capital or otherwise amending articles, and other documents which are required by Luxembourg law to be published will be available to download.

However, the information that is filed at the companies registry is not necessarily up to date; filings can take several weeks to appear online.

The accounts of the target company may not have been independently audited, and may not have been filed on time.

Information request

The best method of obtaining information is likely to be by way of direct request to the seller, the target company and their advisers.

The scope of the request will need to be carefully drafted, and will typically combine generic and tailored requests.

A general requirement to act in good faith will apply to Luxembourg law governed deals, and it is likely that this will extend to the interaction between the parties at the due diligence stage. In addition, a claim for fraud or vices du consentement could be available under Luxembourg law where the seller deliberately misleads the buyer.

The seller's willingness and ability to respond to the buyer's information requests will be driven by the sale process, which may comprise multiple phases, as well as the sensitivity of the information requested and applicable confidentiality restrictions.

Beyond contractual confidentiality undertakings, mandatory obligations of professional secrecy will apply in certain Luxembourg sectors, data protection rules may need to be considered, competition law may be relevant and employee-related data will need to be carefully handled. Specific rules apply to the disclosure of material information by listed target companies.

A non-disclosure agreement between the buyer and seller will be essential, (not least from the perspective of management, who owe duties to act in the target company's interests), as will security measures and rules relating to the data room (whether virtual or physical).

Common Due Diligence Issues

Title to shares and other securities/instruments

A key issue when carrying out due diligence on a Luxembourg target company will be title.

Does the seller have good title to the Luxembourg company, and does the Luxembourg company have good title to the participations in its subsidiaries and other assets?

The starting point will be the share register or, in the case of bearer shares, the bearer certificate(s). Any flaws in the share register will need to be rectified prior to closing.

It is common for Luxembourg companies to be borrowers under "PPLs", "PECs", "CPECs" and other debt instruments with profit participating and/or convertibility features. It will be essential to identify and either extinguish or acquire those instruments.

Transferability and approvals

Another key issue will be transferability, with respect to shares and any other instruments or interests that are to be acquired. A transfer of shares in an S.à r.l. to a third party will require the prior approval in a general meeting of shareholders representing at least 75% of the share capital. This threshold could be higher depending on the articles of association of the target.

Contractual transfer restrictions and/or pre-emption rights could also apply. Many Luxembourg companies act as joint venture or co-investment vehicles. The agreements governing those arrangements are likely to include transfer restrictions.

In the event that a drag-along clause, put/call option or other form of forced transfer provision is intended to be relied upon, advice will be required as to its enforceability plus that of any ancillary mechanism such as voting agreement or standing power of attorney.

The SPA may need to contain targeted conditions precedent as to the granting of consents and the waiver of existing transfer restrictions or pre-emption rights.

Change of control provisions

Luxembourg companies often act as borrowers, guarantors or providers of security in relation to external debt. The change of control of a Luxembourg company could lead to an acceleration or enforcement event under the relevant financing or security documentation. An agreed approach will be required as to how to deal with the external financing and related security arrangements. Any share pledge over the target shares would need to be released or otherwise dealt with, as would any guarantee or security that relates to the obligations of out-of-scope group entities.

More widely, the effect of a change of control will need to be investigated. The termination provisions of key contracts and the possibility that some of them may be terminable by the counterparty due to their personal or intuitu personae nature will need to be assessed. A Luxembourg holding company may have entered into arrangements with management which contain change of control provisions giving rise to severance payments. As a general principle, Luxembourg law governed contracts that do not include a specific term are capable of being terminated upon reasonable notice, at no cost and without liability. A thorough review of material contracts will be required in order to identify and assess these risks.

In the event that the transaction is to take the form of a merger, a demerger or some other form of universal transfer of assets and liabilities, the general principle (assuming the statutory requirements have been satisfied) is that assets and liabilities will automatically transfer to the acquirer by operation of law. Due diligence will be required in relation to the liabilities, and to verify whether the merger or other form of universal transfer will be effective with respect to all of the target company's assets and liabilities. There may be certain contracts and certain types of assets which require the satisfaction of specific formalities in order for their transfer to be perfected, the transferability of intuitu personae contracts will need to be considered, and certain contracts may contain provisions that expressly give rise to a right to terminate in the event of a merger or universal transfer.

Regulatory issues

If the target company carries on a regulated activity (which is not always obvious) a key focus of the due diligence will be ensuring that all necessary licences and authorisations are in place and have been complied with, and understanding to what extent regulatory approval of the deal will be required. Correspondence with, filings to and reports by the relevant regulator will need to be carefully reviewed, and an understanding of the practical consequences of issues that are identified will be required.

Other areas of investigation

An investigation will be required in relation to the liabilities or contingent liabilities of the target, for example on-going litigation, threatened claims or potential exposure in connection with prior transactions. Were all previous corporate actions undertaken in compliance with applicable law, and what are the practical implications if they were not? Could there be, for example, a latent financial assistance issue? Did the target company or its subsidiaries grant warranties or indemnities in relation to past disposals? Are the target company or any of its subsidiaries subject to any non-compete or exclusivity arrangements that will impact the future plans of the buyer?

Tax due diligence will include an analysis, to the extent possible, of whether the target company is effectively managed from Luxembourg and whether tax returns have been duly filed and tax duly paid. A properly managed Luxembourg holding company is likely to have held regular board meetings with substantial supporting documentation. The minutes of these meetings are often a good source of wider information on the target group.

Where the target is an operating company, the buyer will want to understand to what extent the target company can stand alone or is reliant on the seller's group, how complex and costly any required carve-out and integration would be, and the need for transitional services. Other areas to be investigated could include employment, real estate, environmental, intellectual property, data protection and information technology.

Conclusion

The purpose of this article is to raise awareness of the importance of effective buy-side due diligence, and some of the issues that frequently arise on acquisitions of Luxembourg companies. There may be many other areas of investigation depending on the nature of the target and its activities. It will be crucial for the buyer to ensure that its advisers understand the rationale for the acquisition and the buyer's on-going strategy with respect to the target.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.