In a market seemingly experiencing increased pricing for high-quality targets there appears to be a rise in the number of club deals, the term referring to the position where investors pool resources and share risk with the aim of acquiring larger or pricier targets. Club deals have the benefit of enabling investors to acquire assets which would ordinarily be out of scope for the individual investor alone, but such acquisitions come with the complexity of co-investors.
Due to its flexible corporate laws, lender friendly collateral law, AAA credit rating and various other investor friendly benefits, Luxembourg has long been a favourite jurisdiction of private equity investors when it comes to structuring investment vehicles for European targets. It is therefore no surprise that Luxembourg is a preferred choice jurisdiction for establishing the corporate entity facilitating any club deal.
In this article, the authors address the main aspects to be considered when structuring a co-investment vehicle via a Luxembourg company.
In addition to the Company Law1 and its articles of association, a co-investment vehicle will ordinarily be subject to the provisions of the co-investment agreement, a private contract containing the rules on, amongst other matters: (i) the governance of the company, (ii) the transfer of its shares and exit, and (iii) funding, anti-dilution rights and distributions.
1 Law of 10 August 1915 on commercial companies, as amended
The Company Law recognizes several types of entities with or without legal personality, all of which can be used for a club deal vehicle. In practice, a private limited liability company2 commonly called an SARL, dominates the co-investment market, with public limited liability companies3 or SAs used most commonly in the alternative where the peculiarities of the deal require this.
The choice of legal form depends on various legal and tax considerations, particularly: (i) whether the company should have legal personality or not, (ii) be tax transparent or opaque, or (iii) accommodate a clear split between economic and control rights (e.g., by allowing non-voting shares or other equivalent instruments).
By means of example, an SA may be more suitable: (i) where there is a particular need for confidentiality of the identity of any one shareholder (as the names of shareholders are not published as is the case with the SARL), or (ii) where certain shareholders require non-voting shares (an SARL not being able to issue non-voting shares where more than one shareholders are involved), or (iii) where the issuance of equity instruments by the investment vehicle to the public is needed at closing. In contrast, the SARL generally attracts less administrative costs and is an entity capable of election as a corporation for US investor purposes and so is ordinarily preferred.
Although many other legal forms are available to structure club deals, this article will focus on the SARL for the reasons stated above and analyse some of the most common clauses used in club deals and important considerations to be kept in mind when using these clauses in an SARL.
2 société à responsabilité limitée
3 société anonyme
The main bodies: the general meeting and the board
According to the Company Law, the general meeting of shareholders has the widest powers to adopt or ratify any actions relating to the company.
These powers of the general meeting normally derives from ability to appoint and remove the board. The board will be composed of members appointed in accordance with the rules set out in the co-investment agreement and the articles of association. Often, these documents will include nomination rights whereby shareholders make sure that they have an individual say on the manner in which the board is composed.
The board of directors on the other hand has the widest powers to manage the company and take any action relating to its purpose, subject to any limitations imposed by the articles of association or decisions of the general meeting.
When negotiating the co-investment documentation investors face an important question: are they comfortable with the wide management powers of the board or do they want to ensure that certain decisions cannot be adopted by the board unless the general meeting or a certain shareholder has pre-approved the matter? In the latter case, investors will end up defining a list of so-called “reserved matters”. Investors that are not represented on the board will be particularly concerned with the definition of the “reserved matters” as this is often the most important contractual instrument to secure their participation in material decision-making.
That being said, reserved matters cannot be too extensive otherwise there will be a risk of de facto management qualification and so board nominations and board control may become more important. The usual approach where reserved matters are not used is to have co-investors elect different classes of directors, such as class A and B directors with quorum and majorities for passing board resolutions requiring a split of both A and B directors depending on commercial requirements.
As an alternative, investors with no board representation will sometimes wish to at least secure a board observer seat. The observer will not be given voting rights, but will normally be entitled subject to confidentiality obligations to attend board meetings or receive board packs on the board’s initiative.
In accordance with the general rules concerning collegial bodies, general meeting decisions are taken in principle by a majority of the votes of the shareholders present or represented. The articles of association may, however, determine more stringent quorum and majority rules (such as, for agreed “reserved matters”). Certain extraordinary decisions, such as an amendment of the company's articles of association requires the positive vote of shareholders representing at least three quarters of the share capital.
Board decisions on the other hand will be adopted in accordance with the rules set out in the articles of association. The co-investment documentation will often include provisions requiring certain specific quorum and majorities for a list of agreed matters.
One share, one vote?
The “one share, one vote” is one of the underlying principles of the Company Law still applicable to the SARL.
As of 2016, the mandatory application of the principle was loosened with respect to an SA or SCA by the introduction of the possibility for an SA and SCA to issue shares with different nominal value and different voting rights. Such shares will carry voting rights corresponding to the percentage of the share capital represented by them, with one vote being allocated to the share which represents the lowest proportion. For example, an SA could adopt a dual-class share system comprising one class of shares with a nominal value of EUR 0.01 and carrying one vote per share and a second class of shares with a nominal value of EUR 0.10 carrying ten votes shares.
Since 2016, the SARL can also issue shares with different nominal value but not shares with different voting rights. As a result, the possibility to issue shares with different nominal value seems to be of little practical consequence for a SARL. The difference in the nominal value of the shares can instead lead to a number of practical difficulties. Alternative routes, such as the voting arrangements discussed below, will often be considered.
Non-voting shares, waiver of voting rights and voting arrangements
Some investors may be exclusively interested in the profits and returns they can make out of the co-investment and be less concerned with having an active role in decision-making.
In an SA scenario, non-voting shares would be the immediate “go-to” solution. Such non-voting shares will nevertheless preserve their voting rights in certain specific cases, such as a change in the rights attached to them, the dissolution of the company or a reduction in the company's capital.
In an SARL with more than one shareholder, non-voting shares are not available. A written temporary or permanent waiver of the exercise of the voting rights attached to some or all of the shares of the investor will offer a fallback (though not perfectly equivalent) solution.
Compared to the non-voting shares, the waiver of voting rights is limited to the shareholder making it. Potential transferees will not be bound by the waiver. A particular point of concern is the lack of clarity as regards the consequences of the waiver on the applicable quorum and majorities for general meetings. As a result, if the waived rights make-up for what would normally constitute a blocking majority in connection with a certain decision (e.g. more than 25% of the share capital of a SARL as regards decisions to amend the articles of association of the company), that decision will in principle not be able to be adopted while the waiver is in place.
Voting arrangements are also compatible with the SARL, provided that (i) they do not conflict with the provisions of the Company Law or the corporate interest of the company, (ii) they do not require a shareholder to vote in accordance with instructions given by the company, a subsidiary or any of the corporate bodies of such companies or (iii) under such arrangements a shareholder will not promise those companies or corporate bodies to approve the proposals of the company’s corporate bodies. These conditions must be met, failing which the voting arrangement will be null and void.
Voting arrangements are an important pillar for enforcement of various provisions of the co-investment agreement. For example, investors who benefit from contractual board nomination rights should pay attention to secure an undertaking from other shareholders to vote in favour of a proposal made in accordance with the nomination rights. Alternatively (or additionally) binding nomination rights are also possible – such rights are included in the articles of association, become binding on the general meeting and impose conditions for the valid composition of the board. Despite Luxembourg law accommodating contractual and/or binding nomination rights, it is the general meeting that appoints directors as a matter of public policy.
The articles of association of a SARL may allow the board to suspend the voting rights of any shareholder, if the shareholder in question fails to fulfil its obligations under the articles of association or any subscription or commitment deed. This suspension of rights can prove to be a very useful instrument to reinforce the binding nature of a co-investment agreement by adding a statutory sanction in the event of a breach or non-compliance by a shareholder with its respective obligations under the agreement.
A cornerstone feature of a co-investment is usually the stability of its shareholding – the intuitu personae aspect of the co-investment is one of the driving forces behind it. This normally needs to be balanced against the interest of certain investors to retain the flexibility to syndicate their investment and to exit the joint venture vehicle without being the prisoners of their own shares.
Traditionally, the importance of the identity of shareholders was regarded to be a key feature of the SARL compared to a SA – with the latter being normally seen as a pure société de capitaux while the SARL borrows certain limitations that are characteristic to a société de personnes and make it somewhat of a hybrid between the two forms.
This distinction between the SARL and the SA is most visible in what concerns the regime of share transfers. While the shares of a SA are in principle freely transferable to third parties, the shares of a SARL on the other hand may not be transferred to third parties without the consent of the shareholders representing 75% of the share capital (with the possibility to reduce the threshold to up to 50% of the share capital by the articles of association).
Contractual restrictions – how compatible are lock-up, ROFO, drag and tag rights with a SARL?
The stability of the shareholding and the control of the co-investment is usually secured by contractual transfer restrictions over the shares of the co-investment vehicle and change of control provisions included in the co-investment agreement.
Most commonly, one or more of the following restrictions would apply:
lock-up clause: shares cannot be transferred during a certain period of time;
pre-approval clauses (clauses d’agrément): transfers of shares are subject to the prior approval of one or more of the investors;
rights of first refusal: shares cannot be transferred unless they are first offered to one or more of the investors; and
drag and tag rights: securing rights of joint exit for the investors concerned.
These types of clauses are typically valid and recognized in Luxembourg on the basis of the principle of contractual freedom but may be subject to specific conditions depending on the corporate form chosen for the co-investment vehicle.
As regards an SA, the Company Law provides that lock-up clause are valid only if they are limited in time. On the other hand, approval (clauses d’agrément) and pre-emption rights (droit de préemption) are also valid insofar as they do not hinder the transferability of the shares for a period exceeding 12 months as from the notification of request of approval or the invitation to exercise the pre-emption right.
A transfer of SA shares made in violation of the transfer restrictions set out in the articles of association is null and void pursuant to the Company Law.
Transfers of shares in a SARL to third parties are subject to the special statutory procedure which requires that the transfer be approved by the shareholders (as explained above). Before 2016, if such approval was denied the transfer could not have been implemented and the transferring shareholder would have been locked-up indefinitely. In 2016, the Company Law introduced an exit procedure enabling the shareholders to acquire or the company to redeem the shares of the transferring shareholder at a price and in accordance with the terms and conditions provided for in the articles of association.
These legal provisions appliable to the SARL are considered to be of public order and any clause contrary to these provisions are deemed to be unwritten. According to the explanations provided in the parliamentary works relating to the 2016 reform of the Company Law, this last precision was seemingly designed to avoid that the parties could contract out the statutory exit procedure with the effect of the transferring shareholder being entitled to potentially trigger a premature dissolution of the company.
Despite these declared intentions, the legal prohibition of clauses contrary to the statutory exit procedure resulted in significant confusion in practice. In particular, in the months following the entry into force of the 2016 reform package, there was significant uncertainty as to whether transfer restrictions which would delay or prevent the application of the statutory exit procedure are compatible with the SARL at all. This position of course drives a coach and horses through the features of the SARL and unreasonably translates into an implied right for any shareholder of the SARL to force a statutory exit procedure in breach of contractually agreed transfer restrictions. Needless to say that this was not one of the declared consequences that the legislator intended on the introduction of the statutory exit procedure.
Despite the very theoretical arguments to the contrary that can be made, we reasonably believe that the statutory exit procedure should not be incompatible with reasonable transfer restrictions which do no conflict with the corporate interest of the company. This seems to be in line with the position currently adopted by other practitioners in Luxembourg, as the SARL continues to be one of the most commonly used co-investment vehicles. An interpretation to the contrary would lead to what we believe to be a consequence unintended by the legislator where shares in an SA may be subject to restrictions (provided that they are reasonable and do not conflict with the corporate interest of the company) whereas a shareholder of a SARL can always force an exit by relying on the statutory exit procedure.
Investors should be advised that contractual restrictions are often sophisticated and there is no “one-fits-all” approach that can be formulated. These provisions should be carefully reviewed, to ensure that on a case-by-case basis they do not conflict with the statutory rules.
Doubling transfer restrictions – potential conflict between articles of association and the private co-investment documentation
Transfer restrictions included in the co-investment documentation will often be replicated in the articles of association. This ensures that they are made enforceable towards third parties who are otherwise agnostic of the contents of the private agreements between shareholders.
Investors should therefore pay attention to the interaction between the articles of association, a Luxembourg-law governed instrument, and the co-investment documentation, which is often governed by foreign law. The inclusion of the transfer restrictions in the articles of association therefore creates new rights and obligations for investors governed by Luxembourg law. These rights and obligations may be enforced separately from those originating from the co-investment agreement. Potential conflicts should therefore be taken into account when deciding the scope and nature of the transfer restrictions to be included in the articles of association.
Luxembourg law offers ample flexibility for structuring the economic rights of shareholders and their entitlement to profit. One important limitation to this flexibility is the prohibition of the so-called "clause léonine", pursuant to which a shareholder would be excluded from sharing in the profits and losses of the company.
Clause léonines are null and void under Luxembourg law, with the effect that distribution principles contracted in breach of the prohibition will be submitted to the default pro rata allocation principle.
The Luxembourg Civil Code provides for a safe harbour from the clause leonine interdiction. Arrangements between shareholders (whether current or future) which are aiming at organising the assignment or acquisition of social rights but do not otherwise have the purpose of altering the participation of shareholders to profits or their contribution to losses are exempt from the clause leonine prohibition.
In practice, the clause leonine interdiction raises a number of complexities and may be disguised in less apparent circumstances. For example, unless it falls under the safe harbour rule mentioned above, put option arrangements between shareholders and/or the company may be deemed to be in breach of the interdiction to the extent that they secure a guaranteed return for a shareholder with the consequence of excluding that shareholder from suffering potential losses that the company may incur.
Notwithstanding the above, the possibility of creating classes of shares with different economic rights is currently expressly recognised by Luxembourg law. On this basis, tracking shares i.e. shares whose financial rights depend on of returns pertaining to an underlying asset (thereby allowing different shareholders to benefit from returns from different assets held through the same co-investment vehicle), or preference shares may be made compatible with the "clause léonine" interdiction and are frequently used in private equity deals.
It is common for shareholders to agree on their economic rights and the order of payment of their return, often referred to as “waterfall”, in co-investment agreement concluded under private seal. Insofar as these economic rights are linked to the shares, the economic rights of the different shares and the relevant waterfall are normally included in the articles of association of the co-investment vehicle.
The Luxembourg SARL is widely used in practice as a co-investment vehicle due to the flexibility of its regime and the ease of its constitution and management. The SA on the other hand will be the preferred choice when the particularities of the deal require it.
Other company forms are also available under the Luxembourg framework if any restrictions in either mentioned form are not acceptable to the investments.
The final choice of a co-investment vehicle will have to be analysed on a case-by-case basis to ensure that the form chosen best meets the peculiarities of the investment and the terms of the commercial agreement reached between the parties.