Repurchasing distressed debts: a solution to banks’ problems?

Stricter banking regulations mean the need for additional capital. The banks are still suffering losses brought on by the on-going financial crisis. While waiting to find means to reinforce their capital, certain banks are tempted to transfer, either temporarily or permanently, the mortgage liabilities which are rapidly consuming their capital.

Generally, the restrictions on the banks’ lending capacity encourage them to transfer the non-profitable liabilities in order to restore their lending capacity.

The repurchase of distressed debts is needed in order to overcome the problems in which the banks are facing.

Debtor’s perspective:

Imagine a company has bought a property for the value of 100. It is financed by shareholders equity at 30 and a loan from the bank at 70. Due to the financial difficulties, the property is now estimated at 55. The loan has covenants which provide for the use of guarantees, notably in the case where the value of the property is reduced. The debt is secured by a mortgage (“inscription de privilège de prêteur de deniers”) and a pledge on the shares of the company.

Even if it transfers the property, which is worth 55 compared to an original value of 100, the company can’t pay back its’ debt or the guarantees. The company could also be liable in the case of a management fault.

Creditor’s perspective

Imagine a company is debtor for a liability of 70 with a pledge on the company’s shares which benefits the bank. The bank transfers the liability with a nominal value of 70 for 60 to another company.  The bank has two possibilities: either it is forced to increase the interest rates; or the bank transfers its’ non profitable liabilities in order to meet its targets due to the restrictions on its lending capacity.

For an asset bought for 100 and now valued at 55, the bank would have to constitute a provision of 15 (70-55=15). Consequently, the bank would be inclined to transfer the liability for 60. In this case, the bank would make a loss of 10 (70-60=10) and a corporate tax saving of 3 (10×33 1/3%=3). The bank would limit its actual loss to 7(10-3=7).

Transferee’s perspective

The bank transfers the liability with a nominal value of 70 to the transferee company for 60. The debtor company then buys back the shares for 1euro each from this company. The transferee company has therefore bought the liability for 60 with a nominal value of 70 and a current value of 55. The transferee company enforces its’ right from the pledge on the debtor company’s shares and releases through this company a loss of 45 (100-55=45). The transferee company therefore makes a corporate tax saving of 15 through the debtor company (45×33 1/3%=15). This solution is possible as under French tax law there’s no questioning of deficit or potential losses in the case where there’s a change of control, except of course in the case where there’s an abuse of law.

From an economic point of view, it’s necessary to consider certain modified regulations brought about by recent laws. The Financial Law 2011 provides a cap for the use of deficits. It is the transferee who controls the calendar for tax losses, which is only potential as long as the property is not transferred. Implementing a fiscal integration between the transferee and the debtor company allows the transferee to directly control the deficits at the appropriate time.

This operation could present certain difficulties with regards to the monopoly of the banks, litigious redemption and guarantees.

The bank’s monopoly

In the case where buyers of the liabilities are investors but not credit institutions, we must examine whether the repurchase of such liabilities is likely to breach the banking monopoly. No entity other than a credit institution is permitted to carry out banking transactions or provide payment services on a regular basis. Nor can they receive equity from the public either immediately or for a term of less than two years[1]. Any person acting as an entity or on their behalf who ignores these bans may be sentenced to up to three years in prison and ordered to pay a fine of up to 375.000 euros. However, the French Supreme Court “Cour de cassation” has stated that transactions carried out by unauthorised persons in breach of the monopoly are not necessarily null and void[2].

Banking transactions can be classified as follows:

     Receiving money from the public[3] in the form of a deposit with the right to use the money as long as they replace it.

    Credit transactions[4] such as the immediate or deferred availability of funds, or leasing transactions with a call option.

   Payment services[5] which include the possibility for funds to be transferred and cash services.

With regards to the banking monopoly, the repurchasing of distressed debts cannot be considered to be any of the above three mentioned transactions. No equity is made available except in the situation where a new loan is granted.

Litigious redemption

It is the possibility for the debtor of a disputed right to discharge the debt by reimbursing the transferee the price of the transfer when the creditor has transferred his debt[6].  The debtor must pay the price of the transfer, any eventual costs and any interest. The transferee’s consent is not required[7].

Conditions concerning litigious redemption:

        The right can be exercised only after being disputed – a procedure must be in place at the time of the transfer. The procedure must concern the substance of the case[8]. The litigation must still be on going at the time of the litigious redemption[9].

          Redemption can only be exercised by a defending party[10].

       There must be an actual transfer. For example, a transfer resulting partially from shares under the scission regime does not constitute a transfer allowing the use of litigious redemption[11].

 In this context, it’s possible to transfer the asset in two ways:

    The transfer of several assets for a fixed price: as long as the assets can be individualised[12], a transfer made for a fixed price calculated statistically and not on a case by case basis is not, in itself, enough to exclude the application of article 1699 of the Civil Code.

          The “earn out”: by way of an additional price according to the result of the procedure. It is not uncertain as it is determined according to the collection of funds. The earn out does not prevent the litigious redemption[13].

Insolvency proceedings will mean that the debtor cannot exercise the litigious redemption. A repayment or liquidation judgement means that the debtor cannot pay off any debts which arise before the judgement[14]. Similarly, the liquidator, who must act in the parties collective interests, cannot exercise the litigious redemption[15].


Covenants are stipulations included in the loan agreement. They oblige the borrower to respect certain financial norms such as particular ratios and debt restrictions. Covenants can also prohibit the borrower from providing security and from taking out new loans without the agreement of the lender. In the case where these stipulations are not adhered to, penalties include the immediate reimbursement and readjustment of the tariff conditions. The effects of the covenant can always be limited for different reasons. These include declaring a debt, the prohibition of paying off debts which arise before the judgement and therefore the paralysis of the immediate reimbursement.

This type of investment will undoubtedly expand in the coming years due to the financial benefits for the lending parties. 

[1]Article L511-5 Monetary and Financial Code

[2]Cass. Ass. Plen. 4 March 2005, no.524

[3]Art. L.313-2 al1 Monetary and Financial Code

[4] Art. L.313-1 Monetary and Financial Code

[5] Art. L.313-3 Monetary and Financial Code

[6] Art. 1699 Civil Code

[7] Cass. Com 19 December 2006, no. 04-15.818

[8] Cass. Com 26 February 2002, no. 99-12228

[9] Cass. Com 13 November 2007, no. 06-16965

[10] Cass. 1st civ. 20 January 2004, no. 00-20.086

[11] Cass. Com 5 October 2004, no. 00-21955

[12] Cass. 1st civ. 4 June 2007, no. 06-16746 and Cass. Com 27 May 2008, no. 07-11428 07-11530

[13]Cass. Com 13 November 2007, no. 06-16965

[14] Cass. Com 12 October 2004 no. 03-11615 and Cass. Com 14 February 2006, no. 04-13907

[15] Cass. Com 9 May 2007, no. 06-11275

ILO – Banking – France – March 2013