Boglárka Zsibrita

Financing banks only had a short time to make use of the collateral structures transformed due to the revised pledge rules of the new Civil Code. A resolution recently passed by the Highest Court presents banks with a new challenge: financiers will, again, need to reconsider the collateral structures that have been developed and used over the years.

While reviewing a legal dispute involving real estate financing, the Highest Court declared that if a bank registers a pledge on a future claim to secure a loan agreement and in the meantime the borrower goes into liquidation, in respect of the claims not yet due at the start of liquidation the bank cannot exercise its priority of satisfaction. With this judgment the Highest Court has put a stop to an inconsistent judicial practice that has been going on for years.

The case

The court’s decision was related to the financing of an office building investment project, where – in accordance with standard market practice – the financing bank registered a pledge on the future rental income to be derived from renting out the office building. The borrower went into liquidation and during the liquidation procedure the bank, citing its pledge, demanded to receive the rent payable by the tenants.

The court, however, decided that the bank’s demand was unlawful. It believed that, after liquidation is ordered, a bank that is the beneficiary of a pledge can only cite its priority of satisfaction (i.e. its right to receive the rental income before any other creditor) in respect of rent that became payable before the start of liquidation. The court established that claims stemming from a rental agreement crystallise gradually, in line with the falling due of the rent. In other words, rent that becomes payable after the start of the liquidation is not covered by the priority enjoyed by the pledge-beneficiary bank. Therefore, rent that falls due after liquidation is ordered forms part of the general liquidation assets, which the bank can only receive a share of pursuant to the general rules of bankruptcy law.

The impact of the resolution

The resolution could shake the very foundations of financing transactions related to real estate investment projects. In such transactions, one of the banks’ most important collateral securities used to be that they could seek satisfaction from rent payments – especially if the borrower went into liquidation. This collateral item will effectively be lost, as banks will not be able to get their hands on the rent at the time they are expected to need it the most (i.e. when the obligor goes into liquidation, i.e. the repayment of the loan becomes uncertain).

Although the professional soundness of the Highest Court’s decision is disputed in the legal community, lower-level courts will (due to its “in principle” nature) have to take it into account in the future. So financing banks cannot afford to ignore the provisions of the resolution in their lending transactions.

What to expect

Losing one of the most important collateral elements in real estate development deals is expected to be reflected in the pricing of such deals in the future as, based on economic business, a higher risk must be accompanied by a higher return.

Furthermore, the Highest Court’s decision may force banks to reconsider their collateral arrangements. They are likely to focus on other types of collateral again – including the so-called security assignment, which the Civil Code has permitted again since last July or the provision of an option for collateral purposes.

Perhaps the most worrying aspect of the story is the lack of stability: the coming into force of the new Civil Code in March 2014 and the revision of pledge rules last July both had a significant impact on the collateral structures banks use. The Highest Court’s most recent decision will now force banks to reconsider their collateral structures for the third time in three years.