Distressed-debt investors appear to be setting their sights on Italy in search of opportunity as the country's banks begin the process of deleveraging to meet new capital regulations. According to data compiled by the Italian Banking Association, approximately 166 billion euros of non-performing loans were on bank balance sheets as of this past summer which was up from 42 billion euros in 2008. Delinquent loans as a proportion to total lending grew to 8.9 percent as of May, 2014 which is the highest that figure has been in more than fifteen years. The potential upside is apparently huge but as with any reward there are risks. The following is a brief overview of some of the legal issues investors may want to consider before investing in Italian distressed loans.
Choice of Law
Loan agreements arranged for Italian borrowers are typically governed by either Italian law if the issue is intended solely for the Italian market or English law if the issue is intended to appeal to foreign investors. Such choice of law provisions are generally upheld by Italian courts pursuant to Regulation (EC) No. 593/2008 ("Rome I") which became effective July 24, 2008 and applies to agreements effective as of December 17, 2009. Under Rome I, the contracting parties' freedom of choice is given considerable weight though there are certain exceptions including situations where (i) the choice of law is fraudulent; (ii) the application of the chosen law is incompatible with the public policy of the forum; or (iii) the law chosen is not that of an EU Member State and contradicts the provisions of EU Community Law. Investors should be mindful that, while choice of law provisions are generally upheld, there are situations where such a choice may not be honored by the Italian courts.
Transferability of Interests
Pursuant to Legislative Decree No 385 of 1 September 1993 (the "1993 Banking Law"), only domestic Italian financial institutions and foreign financial institutions duly authorized by and registered with the Bank of Italy may engage in lending activities. As a result of these limitations, a fronting structure known as the Italian Bank Lender of Record ("IBLOR") system was developed to allow unregistered foreign financial institutions to gain exposure to the Italian loan market. Under the IBLOR structure an Italian financial institution, the lender of record, lends directly to an Italian borrower. The lender of record then enters into financial arrangements (e.g., sub-participations, cash-collateralized guarantees) with unlicensed foreign financial institutions.
Although the IBLOR structure affords foreign investors the opportunity to gain exposure to the Italian loan market there are drawbacks. Because of the nature of IBLOR, foreign investors are subject to credit risk not only as it pertains to the Italian borrower but also with respect to the Italian fronting bank. Moreover, investors do not have direct recourse against the borrower and generally have very limited influence on the management of the loan by the Italian fronting bank thus leaving them with little to no leverage to re-negotiate the capital structure of the borrower in the event of insolvency. Investors should be aware that, if direct influence were established, the Italian tax authorities could seek to classify the Italian fronting bank as a mere "conduit", alleging a direct relationship between the borrower and the foreign investors. In the event of such a finding, Italian authorities could (i) declare the structure in violation of applicable Italian banking laws and collapse the structure and (ii) determine that withholding tax should apply to interest paid by the borrower to the Italian fronting bank. While there does not appear to be a clear line as to what constitutes direct control, it seems that the more control given the greater the risk the Italian authorities will step-in.
In an attempt to promote investment in Italy, the Italian Government adopted Law Decree No. 145/2013 (also known as Destinazione Italia).[1] Destinazione Italia seeks, among other things, to increase access among Italian companies to medium/long-term financing. Under the new law it may be possible for foreign financial institutions to purchase Italian loans through an Italian special purpose vehicle ("SPV") without the intermediation of a bank as is the case under the IBLOR structure provided certain conditions are satisfied. Essentially, an Italian bank extends a medium/long-term secured loan (i.e., a loan with a maturity exceeding 18 months) to an Italian borrower and, once it's been on the bank's books for a certain period of time, it may be assigned to an SPV which may then turn around and sell interests, such as asset backed notes, onward to foreign investors.
While several of the risks noted above as to IBLOR remain there are benefits to the structure developed under Destinazione Italia including:
Withholding Tax - unless a double-taxation treaty is in place, payments of interest to non-Italian investors are subject to 20% (26% for interest accruing from July 1, 2014) withholding if made by an Italian borrower or by a non-Italian borrower from Italian source interest. The Decree repeals the application of withholding tax for interest payments on bonds issued by the SPV to its investors provided they hail from "white list" countries identified in the Ministerial Decree of 4 September 1996, as amended.
Claw-Backs - typically payments can be clawed-back by a receiver in bankruptcy if the borrower becomes insolvent within one year from the date on which the payment was made. The Decree exempts any prepayments made to an SPV under a securitized loan in the two years prior to the borrower's insolvency from being clawed-back.
Account Segregation - it is possible for the SPV to segregate, and thus protect, distributions received under the credit agreement from being included in the bankruptcy estate in the event the borrower becomes bankrupt.
Single Investor - asset backed securities issued by an SPV can be held by a single investor without any re-characterization risk so long as it is a qualified investor ("investitore qualificato").
Security Interests Against Collateral
Under Italian law, trusts and trustees are not recognized. Accordingly, security interests granted in connection with a lending facility are given in favor of lenders individually. In order to deal with this situation, Italian credit agreements will typically provide for the appointment of a collateral agent who is authorized to act in the name of and on behalf of the other identified secured parties. The benefit to such an appointment is that it allows the collateral agent to execute the security documents (including security confirmations in the event of a change in the lenders of record) on behalf of the other secured creditors, to exercise their rights thereunder and to enforce the security. It should be cautioned, however, that such an arrangement does not eliminate the requirement that security be granted, registered (if required) and enforced in favor of each lender individually.
In the context of a fronting structure where a foreign investor is typically taking the loans via sub-participation, for example, the investor will not be deemed a lender of record and thus there should be no adverse consequences related to the perfection of any and all pertinent security interests. The investor will not be deemed a secured creditor and will have no rights under the security other than those provided by the credit documents such as sharing provisions. Nevertheless, as part of its due diligence it is incumbent upon investors in Italian credits to insure that the fronting bank/SPV is specifically identified in the security documents as a beneficiary.
[1] Destinazione Italia was enacted on December 23, 2013 and was converted into law on February 19, 2014, with amendments.
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