Effective Management of Non-Performing Loans: Market Impact of the Proposed EU Measures

On March 14, 2018, the European Commission published its Proposal for an EU Directive containing a substantive package of measures designed to facilitate the management by banks of existing and future stocks of non-performing loans (NPLs) on their books. A loan is classified as an NPL where payment is more than 90 days overdue or where the loan is assessed as unlikely to be repaid by the borrower. NPLs have beleaguered the European markets since the onset of the Eurozone crisis in 2008, causing losses, reducing capital and inhibiting banks’ capacity to lend new money, in particular to SMEs and innovative businesses that drive the economy

Objectives of the Proposed Directive

The Directive aims to prevent excessive build-up of NPLs on banks’ balance sheets in the following ways:

1. By facilitating the development of a liquid secondary market in NPLs through a common regime across the EU for:
   1. the sale of loans to non-bank “credit purchasers” that have the necessary risk appetite and expertise to manage the loans.
   2. the outsourcing of loan servicing to specialist non-bank “credit servicers.”
2. By increasing the efficiency of debt recovery procedures for secured loans through a common “accelerated extrajudicial collateral enforcement” mechanism.

Regime for Loan Transfers to Non-Bank Purchasers

In relation to loan transfers to non-bank institutions, the Directive provides the following principles:

1. Compulsory prescribed levels of disclosure for loan transfers to non-bank purchasers.
2. Notification of prescribed details to competent authorities by the transferor on any sale of a loan to a non-bank transferee.
3. Requirement for non-bank loan purchasers who are not established or domiciled in the EU to appoint a representative in the EU.
4. Requirement for a non-bank loan transferee to pre-notify the national authority of its intention to enforce the loan, together with provision of prescribed information.

In order to promote the efficacy of this common regime across the EU, the proposed Directive further requires the lifting of any existing national restrictions on the purchase of loans by non-bank credit purchasers beyond those implemented by the Directive itself.

Regime for Non-Bank Credit Servicers

A “credit servicer” is essentially defined as an administrator of a loan on behalf of a creditor, including monitoring performance, notifying interest rates, administering payments and enforcing the agreement. The Commission notes that these functions are largely unregulated — or inconsistently regulated across the EU — when carried out by a non-bank entity.

The proposed Directive seeks to promote the consistent development of the secondary market in NPLs by implementing a common set of rules to which third party non-bank credit servicers must adhere in order to operate within the EU under which they are required to obtain authorization and maintain requisite standards under the regulation and supervision of the relevant Member State.

Accelerated Extrajudicial Collateral Enforcement Mechanism

The proposed Directive introduces a common “accelerated” out-of-court procedure for enforcing against moveable and immovable collateral taken under secured loans to business borrowers where this enforcement mechanism is pre-agreed in the loan transaction and specified conditions are met. Member States will be required to ensure that they provide for at least one of the proposed accelerated means to realize the collateral, namely, by way of public auction or private sale.

In its explanatory commentary the Commission notes that while banks can enforce security under national insolvency frameworks, in certain cases - including where the collateral must be enforced in a Member State other than the home State of the lender — this can be costly, cumbersome and unpredictable and hence undermine the liquidity of the secondary market in NPLs. The Directive seeks to address this through a common “accelerated extrajudicial collateral enforcement” (AECE) mechanism to encourage lenders and borrowers to transact across Member States and thereby to promote free movement of capital and market liquidity.

In practice, whether the AECE mechanism would have any benefit in the U.K. is debateable, given that the U.K. already has a flexible out-of-court security enforcement regime unlike some other EU Member States.

Implementation Process and Response to the Proposed Directive

The proposed Directive is currently going through the legislative process and the final form of the Directive is expected to be implemented in early 2019. As part of that process there has been an opportunity for market participants to submit feedback to the Commission for presentation to the EU Parliament and Council in order to inform the legislative debate.

To this end, the U.K.’s Loan Market Association (LMA) published its feedback on the proposed Directive on June 8, 2018, following extensive consultation with bank and non-bank LMA members across the primary and secondary syndicated loan markets.

While recognizing the positive legislative intention of the Directive to develop the secondary market for NPLs, the LMA highlighted its concern that the Directive, as currently drafted, brings into scope both non-performing and performing loans and that a number of measures, if adopted in their proposed form, would have negative consequences for the liquidity and efficiency of the primary and secondary syndicated markets.

The LMA highlighted specific examples including:

1. The level of positive disclosure proposed for transfer of loans to non-bank purchasers which would undermine existing long-established secondary market practices around the principle of “buyer beware.”
2. The proposed reporting requirements in relation to non-bank loan transferees, and the requirement for non-EU non-bank transferees to appoint an EU representative which could discourage non-bank market participants from entering into secondary syndicated loan transactions and undermine the liquidity of the secondary market in performing loans as well as in NPLs.
3. The requirement for non-bank loan transferees to inform competent authorities before enforcing a loan, which would make enforcement slower and generally inhibit loan recovery, notably hampering syndicated loan enforcement where the syndicate includes a mixture of bank and non-bank lenders.
4. The new regime for “credit servicers,” as currently defined, could impact syndicated facility and security agency functions, and credit fund structures, where the loan servicing function is outsourced to non-bank loan servicers who may be caught by the regulations in a way that disrupts those functions.

In view of the above concerns and the potential disruption that the proposed Directive could cause to the wholesale loan markets, the LMA suggested certain amendments to exclude syndicated and other wholesale loans from the scope of the Directive and to apply the requirements in a more targeted manner to achieve the desired intent.

In relation to the proposed “accelerated extrajudicial collateral enforcement” mechanism, the LMA welcomed the concept but raised certain issues around its clarity and practical application as well as concerns around identifying which Member State’s implementation procedure would prevail in circumstances where there are differing laws governing the credit agreement, the security agreement and the location of the assets.

We would expect the LMA’s response to be taken into account in considering subsequent amendments to the proposed Directive. Assuming the final form of the Directive is implemented in early 2019, Member States will then have a deadline in 2021 to adopt the Directive into national law. In relation to the U.K., allowing for the implementation period, the Directive is likely to become law only after the U.K. has exited the EU. Credit servicers registered and established in the U.K. would therefore be unlikely to qualify under its regime unless reciprocal passporting arrangements are agreed as part of the Brexit negotiations.