2.1. Amendments that increase the flexibility of the system applicable to the issuance of mortgage securities in general
On 8 December 2007, Law 41/2007 of 7 December amending Law 2/1981 of 25 March on the mortgage market and regulations related to the mortgage and financial systems, regulating the reverse mortgage (“hipoteca inversa”) and the long term care insurance (“seguro de dependencia”) and whereby a specific tax rule is set out (“Law 41/2007”) was published in the Official Spanish Gazette.
Law 41/2007 reforms an important part of Law 2/1981 of 25 March on mortgage markets (“Law 2/1981”) as well as specific provisions of Law 2/1994 of 30 March on the subrogation and modification of mortgage loans (“Law 2/1994”) and the Mortgage Law of 8 February 1946 (“LH”) with the purpose of providing the Spanish mortgage market with greater flexibility, sophistication and efficiency in order to maintain the growth experienced in recent years. A number of reforms have been introduced relating to (i) asset or financing transactions carried out by credit institutions (analyzed in section 1) and (ii) liability transactions, i.e., those of moving of mortgage loans and credits that credit institutions carry out as refinancing mechanisms (summarized in section 2).
Law 41/2007 establishes frameworks for new Spanish legal concepts such as the reverse mortgage and long term care insurance, the minimum transparency and disclosure duties applicable to credit institutions within the context of mortgage loans and credits and the legal statutes applicable to appraisal companies. It also modifies many important legal procedural provisions that are outside the scope of this newsletter.
One of the most significant amendments introduced by Law 41/2007 is the acknowledgment of the possibility of creating cap mortgages (hipotecas de máximo) for securing current and future liabilities even if not fully defined. Legal support is given to this concept which has more commonly been called a floating mortgage. The amendment will only be applicable to those mortgages granted in favour of financial institutions and public authorities (and in the latter case, exclusively to guarantee tax or social security receivables). With this new concept, the historical interpretation of certain Spanish mortgage law principles under which a mortgage could only secure a single liability has been superseded. The new rule will put an end to the recent doctrine of the General Directorate of Registries and Notaries on mortgages securing future liabilities which required, at least for banking mortgages, the existence, upon the granting of the mortgage, of a legal relationship that clearly ascertained the obligation to be secured.
In order to create this type of mortgage, the mortgage deed must include a description of the legal acts which the secured liabilities are or will be derived from, the maximum mortgage liability (which will cover all the obligations without allocating mortgage liability between them), the term of the mortgage and the means of calculating of the final secured amount and payable balance. Given that the method for determining the due and payable amount and that foreclosure actions are not specifically adapted to this type of mortgage, it should be understood that the current legislation on cap mortgages is applicable.
The legal recognition of the floating mortgage is essentially aimed at simplifying and reducing the costs inherent to the need of creating specific mortgages to secure each of the liabilities that may exist between a financial institution and its client. Thus, according to this provision, it is possible to have a single mortgage securing all the liabilities (including those that may be generated in the future, provided that the legal acts from which those liabilities are derived are determinable) of the client towards the financial institution. Such a possibility entails an important reduction of the inevitable notarial and registration costs derived from creation of a specific mortgage for each liability. It also avoids the Transfer Tax (as Stamp Duty) levied on banking mortgages, as neither creating and subsequent cancelling of mortgages to secure several obligations nor equaling the ranking of different mortgages, each created as security of an obligation (which would be subject to tax independently) will be necessary.
It is possible that, in practice, financial institutions will want to increase the amount of the mortgage liability for this type of mortgage (the taxable basis for the Transfer Tax as Stamp Duty) which, depending on the type of financing, currently accounts for approximately 110% of the principal of the credit or loan (according to the data of the Spanish Mortgage Association). The reason is the need for the financial institution to fix mortgage liability upon creation of the floating mortgage that not only secures the existing liabilities but also the various obligations that could be secured by that mortgage (particularly when the coverage of future liabilities is envisaged). That is, an inflation of the figures of the mortgage liability may ever become market practice for floating mortgages (with the consequent tax increase) in relation to the ordinary or traffic mortgages.
Attention should be paid to the usefulness of a floating mortgage for complex financing transactions (e.g., project finance) in which many liabilities exist (e.g., financing the purchase of a building with a senior loan agreement; VAT facility agreement; a derivative agreement to cover the interest rate, etc.). Prior to the acknowledgement of the concept of floating mortgage, if a financial institution wanted to secure various liabilities with mortgages, the creation of a mortgage was necessary in order to secure each of the obligations or financing agreements, having to estimate the mortgage liability to be allocated to each of the secured obligations, with the risk that this assessment not correspond to the actual risk derived from each liability. After the enactment of Law 41/2007, it is no longer necessary for a financial institution to estimate the mortgage liability to cover each of the secured financing agreements. It is sufficient to simply establish maximum mortgage liability cover without differentiating among the different financing contracts. Therefore, with the floating mortgage, financial institutions will not run the risk of some liabilities being undersecured at foreclosure as a consequence of having incorrectly allocated the mortgage liability among the several obligations.
In order to improve and make the mortgage market more flexible, Law 41/2007 (i) extends the possibilities of modifying a mortgage credit without having to create a new mortgage and (ii) attempts to clarify some of the aspects of the regulation applicable to the mechanism of subrogation in mortgage credit and loan agreements referred to in Law 2/1994.
(A) Modification of mortgage loans and credits: Law 41/2007 allows financial institutions (non-financial institutions will not benefit from this legal framework) to modify a number of the conditions of a mortgage loan or credit without having to create a new mortgage or lose the initial rank of the mortgage modified, unless the modifications involve an increase of the mortgage liability or an extension of the credit term. The following mortgage conditions may be altered:
(i) An increase or reduction of capital, thus introducing the French so called “rechargeable mortgage” into Spanish legislation. This allows the possibility to maintain a mortgage granted to secure a banking loan or credit with the same rank even after an increase of the financed capital (e.g., following a repayment);
(ii) the term;
(iii) the conditions of the interest rate initially agreed upon or in force;
(iv) the amortization method or system and any other financial conditions of the loan; and
(v) the granting or modification of personal guarantees.
From a practical perspective, the wide range of modifications allowed by the rule without causing a change in the rank of the mortgage is notable. Nevertheless, the value of the second ranking mortgages may be affected as a consequence of the fact that they will be subject to any changes made to the first ranking mortgages that might reinforce the conditions of the loan (thus facilitating the enforcement of the first ranking mortgages by reducing the “value” of second ranking mortgages). Prior to the enactment of the new law, the modification of a liability secured with a mortgage that could negatively affect a subsequent registered creditor did not cause a change in the rank, provided that the subsequent secured creditors had given prior consent. An exception to the consent requirement was permitted for modifications of the interest rate or extensions in the term within the context of a subrogation by another financial institution under the scope of Law 2/1994.
However, the possibility of modifying novation (not extinctive) in favour of the first ranking secured creditor has been extended. As a result, a creditor with a second ranking mortgage will have to take into consideration that a financial institution with a first ranking mortgage may, for instance, agree with the debtor on a capital increase, a reduction of the term or any other reinforcement of financial conditions of the credit secured with a first ranking mortgage maintaining the rank of first mortgage without obtaining the consent of the second ranking secured creditor, provided that there is no increase in the mortgage liability or in the “term of the credit due to the increase or extension”. While the wording is not entirely clear, it is our understanding that this refers to the term of the mortgage, if should it have been established. Therefore, in our view, the second ranking secured creditor or subsequent registered creditor must give consent to the modification of any circumstances of the banking loan or credit with higher rank when the mortgage liability of the preferential mortgage is increased or when its term is extended, but such consent will not be necessary under any other circumstance.
(B) Subrogation in mortgage loans and credits in accordance with Law 2/1994: The purpose of the amendments proposed by the new rule is to regulate the process of subrogation of financial institutions in mortgage loans or credits under the rules of Law 2/1994. For this purpose, a financial institution that intends to carry out a subrogation must notify the acceptance by the debtor of its binding offer by notarial means so that the initial secured creditor, within the following 15 days, may invalidate the subrogation by declaring before the same notary and on an equally binding basis, its commitment to formalize with the debtor an amendment of the conditions at least equivalent to that proposed by the potentially subrogating entity. This wording clarifies the period for the exercise of the right of refusal (under the previous law, there was some uncertainty as to the calculation of the “dies a quo”, otherwise known as the starting day for calculation), and the legal certainty of the process is improved by means of the compulsory intervention of the notary public for notifications carried out between the initial creditor and the potential subrogating entity. Furthermore, in the event that more than one credit or loan granted by one institution is secured by the same asset, the new credit institution will be required to subrogate all mortgage loans or credits (thus resolving the issues arising from the manner in which the previous law approached the matter).
Nevertheless, it must be noted that the extension of the scope of the modifying novations (not extinctive) of mortgage loans and credits without altering the mortgage rank introduced by means of Law 41/2007 has not amended Law 2/1994 for situations in which subrogation or modification deeds are exempted from Transfer Tax (as Stamp Duty) which remain as follows: (i) subrogation under Law 2/1994 by which the loan term is altered and/or the conditions of the initially agreed to or in force interest rates (ordinary or default) are modified and (b) the novation of these loans exclusively regarding the alteration of the loan term and/or the modification of the conditions of the initially agreed or in force interest rates (ordinary or default) .
Law 41/2007 emphasizes the protection of borrowers, individuals or small sized companies regarding the collection of the so-called “early repayment fees” that will now be known as “compensations”. Law 41/2007 sets out the possibility of establishing two types of compensations: the waiver compensation (“compensación por desistimiento”) and the compensation related to the risk linked to the interest rate. The maximum limit for the waiver compensation will be (i) 0.5% of the early repaid capital if the cancellation (whether in whole or in part or in connection with a subrogation or not) takes place within the first five years of the lifetime of the loan or credit and (ii) 0.25% of the early repaid capital if the cancellation (whether in whole or in part or in connection with a subrogation or not) takes place after the first five years of the lifetime of the loan or credit.
As regards the compensation related to the risk linked to the interest rate, if the period of review of the interest rate is equal to or less than twelve months, the creditor will not be entitled to seek any compensation based on this item. If the period is longer, should the cancellation generate a capital loss for the creditor, the creditor will be entitled to seek compensation that will be either a fixed rate set out in the contract to be applied to the unpaid capital or the reimbursement of the loss generated by the cancellation as calculated according to the formula provided in Law 41/2007. Although it seems that the second option is the most protective of the interests of financial institutions, it gives rise to the risk of mandatorily recognizing the borrower’s right to be indemnified when the cancellation generates a capital gain (as opposed to a capital loss) in favour of the financial institution. As expected, this will encourage clients to make early repayments when the circumstances result in a gain for the institution and thus a right to compensation in favour of the debtor (calculated according to the formula established in Law 41/2007) arises. Nevertheless, this “arbitration” option would only be worthwhile for the client if the compensation were to cover the costs derived from the waiver compensation set out in the contract (which is compatible with the compensation related to the risk linked to the interest rate).
The Third Final Provision of Law 41/2007 includes a number of amendments to the Law on chattel mortgages and pledges without transfer of possession (Ley de hipoteca mobiliaria y prenda sin desplazamiento) of 16 December 1954 (“LHMPSD”) which are relevant for lending transactions in which this type of guarantee is used. Although the preamble of Law 41/2007 makes no reference to the ratio legis underlying these amendments, facilitating and generalizing the use of this type of guarantee on the financing markets seems to be their purpose, given that nowadays, the use of this type of guarantee is certainly ancillary.
Firstly, Law 41/2007 establishes that any contractual clause forbidding the creation of a chattel mortgage or a pledge without transfer of possession over a property already mortgaged or pledged is void while second (or lower) ranking movable mortgages and pledges without transfer of possession are allowed. In this regard, it is important to recognize that Law 41/2007 has not repealed the provisions established in article 55 of the LHMPSD under which pledging by means of ordinary pledge properties that had been already pledged with a pledge without transfer of possession are not permitted. The creation of a chattel mortgage or a pledge without transfer of possession over a mortgage or pledge (as a sub-mortgage) is permitted and the former prohibition for mortgage or pledge seized assets or assets which purchase price has not been totally paid is removed.
Likewise, Law 41/2007 allows for the creation of pledges without transfer of possession over receivables and over other rights held by the beneficiaries of administrative contracts, licenses, awards or subsidies, provided that this is permitted by the law or the corresponding granting title. The registrar will inform the relevant public authority of the creation of the guarantee once the pledge has been registered.
Finally, Law 41/2007 establishes that receivables (including future receivables) other than those represented by securities or those qualifying as financial instruments (according to the Legislative Royal Decree 5/2005 of 11 March, on urgent reforms for the improvement of productivity and public contracting activities) can be pledged by means of a pledge without transfer of possession. In our opinion, after Law 41/2007 entered into force not only pledges without transfer of possession are permissible to pledge receivables (other than securities and financial instruments), but both types of pledging are available alternatively, the pledge without transfer of possession (which requires registration) or the ordinary pledge or pledge with transfer of possession that has been construed by scholars as requiring notification to the underlying debtor when granted over receivables (this interpretation being based on the assumption that notification would give rise to the same effect as the transfer of possession necessary to create an ordinary pledge over movable assets). Notwithstanding this, it should be noted that recent rules, such as article 90.1 of the Spanish Insolvency Law, appear to link the execution and enforceability of a pledge over receivables to the creation of the guarantee by means of a duly dated certified document, thus, notification not being required.
The reforms introduced by Law 41/2007 on the moving of loans secured by chattel mortgage or pledges without transfer of possession are described in section 2.
Law 41/2007 introduces a second paragraph to article 12 of LH that appears to require the registration of early termination and financial clauses related to the liabilities secured by mortgage in favour of those credit institutions referred to in Law 2/1981 in the terms of the mortgage deed “in the event of the registration of the clauses with in rem dimension”. Although these words could be interpreted to indicate that only early termination and other financial clauses with in rem dimension must be registered, according to mortgage principles and standard practice, the General Directorate of Registries and Notaries recently held in two resolutions dated December 21, 2007 (Official Spanish Gazette of 15 January 2008) that this provision requires the registration of the early termination and other financial clauses in bank mortgages even if they do not have an in rem element (considering the resolutions as contrary to the prohibition of registering any clause lacking the in rem element set out in article 51.6 of the mortgage regulations). Should this interpretation be applied generally, it will be possible to register early termination and other financial clauses secured by bank mortgages even if they do not have an in rem element. As a consequence, thousands of disputes initiated over the last century by credit institutions against the rejections of registries to register some of these clauses (which in their opinion, lacked, the in rem element) will be settled. Unfortunately a similar rule for non-bank mortgages is not contemplated.
Law 2/1981 and its implementing regulations established a system applicable to mortgage securities. Mortgage securities can be issued by credit institutions and stimulate the circulation of mortgage loans and credits granted by credit institutions.
There are currently three types of mortgage securities:
1. Mortgage participations (“participaciones hipotecarias” or “PH”). The subscription of PH involves the investor’s participation (either total or partial) in one or more mortgage loans or credits included in the portfolio of the issuing credit entity. These loans or credits must comply with certain quality requirements (known as “eligibility criteria”) which are set out in Law 2/1981. In 2002, the possibility of issuing this type of securities as “mortgage transfer certificates” (“certificados de transmisión de hipoteca” or “CTHs”) was extended to cases where the underlying mortgage loan or credit did not meet all the eligibility criteria set out in Law 2/1981. Nevertheless, the possibility of subscribing CTHs was restricted to Spanish asset-backed securitization funds.
2. Mortgage bonds (“bonos hipotecarios” or “BH”). The capital and interest of mortgage bonds are specially guaranteed by a portfolio of mortgage loans and credits registered with the relevant property registries in favour of the issuing entity.
3. Covered bonds (“cédulas hipotecarias” or “CH”). The capital and interest of covered bonds are specially guaranteed -without the need for registration- by all mortgages registered from time to time in favour of the issuing entity.
In general terms, the issuance of mortgage securities does not give rise to significant tax and administrative costs, and it is protected in the event the issuer becomes insolvent. These are only some of the reasons why it has become the most commonly used instrument for Spanish credit entities that wish to move large mortgage portfolios, be it directly or through securitization structures.
Nevertheless, developments in banking and financing practices in recent years have made it necessary to update the regulations on mortgage securities. The changes introduced by Law 41/2007 in this field are as follows:
1. Amendments that increase the flexibility of the system applicable to the issuance of mortgage securities in general;
2. Amendments to the mortgage bonds system;
3. Measures to reinforce investor protection;
4. Other reforms.
2.1. Amendments that increase the flexibility of the system applicable to the issue of mortgage securities in general
Law 41/2007 introduces some measures aimed at sophisticating the legal system applicable to mortgage securities (especially in relation to CH and BH), by providing credit entities with alternatives for the structuring of issue transactions:
1. The underlying assets eligible to secure CH and BH have been supplemented: their issuance can be guaranteed not only with mortgage credits and loans, but also with so-called “substitution assets”. The latter are generally low-risk and highly-liquid assets as set out in Law 41/2007, and include, among others, fixed income securities issued by the State or highly-rated securitization funds. These contribute towards mitigating the liquidity risk usually associated with these types of issuances. The issuance of BH and CH can be secured by these substitution assets up to a maximum of 10% and 5% respectively, over the principal issued.
2. The eligibility criteria applicable to the underlying mortgage loans and credits have become more flexible:
• The purpose of the loans and credits has been extended. It was previously limited to the financing (with real estate mortgage security), construction, refurbishment and acquisition of residential buildings, development works and social buildings, the construction of agricultural, tourist, industrial, commercial buildings, and any other construction work or activity. In addition to these activities (specifying that the mortgage can be ordinary or floating) the eligibility criteria is extended to all other purposes. Therefore, the number of potentially eligible mortgage loans as underlying assets relevant for purposes of calculating the threshold for the issuance of CH, PH and BH has been increased.
• The loans or credits secured with real estate located within the European Union by means of guarantees of a nature equivalent to that defined in Law 2/1981 are now eligible. This means that Spanish credit entities can now move the mortgages granted within the European Union through Spanish legal instruments. The requirements for determining this equivalence, and the conditions for the issuance of mortgage securities that have as their underlying security loans or credits, are still to be developed in the regulations.
• When additional guarantees are granted by insurance companies with respect to a residential loan or credit (e.g., a mortgage insurance), Law 41/2007 provides that the proportion between the capital of the loan or credit and the value of the mortgaged residential asset (i.e., the loan-to-value ratio) can be higher than 80% (which is generally the threshold applied to residential loans or credits for them to be deemed as eligible), but not exceed 95%.
• Credits or loans secured with a first-ranking chattel mortgage or first-ranking pledge without transfer of possession can be moved, according to the terms to be determined by regulations which are still to be enacted. This introduces a novelty in the previous system that is expected to contribute to a wider use of these legal instruments in financing transactions involving Spanish credit institutions.
3. The range of possible CTH investors has been widened. In addition to the possibility of these securities being placed in Spanish asset-backed securitization funds, the First Final Provision of Law 41/2007 allows for CTH issuance to be allocated among qualified investors. These include a large number of prospective investors, such as Spanish and foreign credit entities, pension funds, and undertakings for collective investment. Credit entities will have more alternatives to move their mortgage loan portfolios that do not fulfill all the eligibility criteria. For instance, this measure will facilitate the structuring of Pan-European commercial mortgage securitization transactions, which do not usually comply with the eligibility criteria, where the Spanish part of the deal has been structured either by making an ordinary assignment of mortgage receivables (in practice, triggering a number of notarial, registration and general tax costs), or by inserting a Spanish asset-backed securitization fund as the subscriber of the CTH issued by the credit institution (with an added cost involved). Now that Law 41/2007 has entered into force, these transactions will probably be carried out more efficiently in terms of costs and taxes. This is because the securitization vehicle, which is usually foreign, will be able to directly subscribe to the CTH, as long as this vehicle is considered to be a qualified investor.
BH are the mortgage securities that are used least in practice by credit entities in order to move their mortgages. The main reason for this were the administrative obstacles preventing their issuance before the legislative reform. Therefore, with the aim of promoting their use, Law 41/2007 has amended Law 2/1981 mainly in the following terms:
1. The requirement of registering the loans or credits used as guarantee with the BH issuance deed in the relevant property registries (by means of a marginal note next to the mortgage registration), has been deleted.
2. The setting-up of a bondholder syndicate when issuing BH in series will no longer be compulsory.
3. All mortgage loans and credits subject to a BH issuance must fulfill all eligibility criteria set out in Law 2/1981, and the guarantee provided by such mortgage loans and credits will be granted notwithstanding the unlimited personal liability of the issuing company.
Some of the provisions of Law 41/2007, such as those pointed out below, are intended to improve investor protection (CH and BH investors):
1. As a supplement to the guarantee of the underlying mortgage portfolio, the CH and BH capital and interest will be guaranteed by the substitution assets,(subject to the limits applicable to each case as referred to in section 2.1 above, and by the cash flows generated by the derivative financial instruments connected with each issuance. These guarantees will be subject to the conditions to be further developed by the regulations.
2. The eligibility requirements for non-residential mortgage loans and credits have been toughened, with their maximum loan-to-value ratio decreasing from 70% to 60%.
3. Thresholds for the issuance of CH and BH by credit entities have been modified as follows:
• A credit entity must not issue CH for an outstanding principal amount higher than 80% (formerly 90%) of the unamortized amounts of mortgage loans and credits within its portfolio that comply with the eligibility criteria, after deducting the amount of those affected to the BH.
• The updated value of BH, calculated according to a method to be determined by regulations, must be lower, by at least 2%, than the updated value of the underlying mortgage loans and credits.
4. The Spanish Insolvency Act (“Ley Concursal”) introduced a privileged system for BH and CH holders that, in the case of the issuer’s insolvency, are considered as specially privileged creditors (“acreedores especialmente privilegiados”) with regard to the capital and interest under those instruments. Notwithstanding this, during the insolvency proceeding, payments corresponding to the amortization of the capital and interest under BH and CH issued, and pending amortization at the date of the insolvency application, must be satisfied as credits against the estate (“créditos contra la masa”), up to the amount of the income received by the insolvent from the mortgage loans securing the CH or BH, as the case may be.
Law 41/2007 has reinforced the system on two levels:
• Amounts arising from the substitution assets, and cash flows generated by the derivative financial instruments connected with each issuance, will be relevant for purposes of the limit stated in the previous paragraph.
• A new protection measure has been introduced, which states that, if the income received by the insolvent is insufficient (due to a time gap in the receipt of funds) to cover the payment of the capital and interest under BH and CH, the insolvency trustee (“administración concursal”) will have to pay them by liquidating the substitution assets subject to the issuance. If the amounts gained from liquidation are not enough to cover the capital and interest due, the insolvency trustee will be obliged to carry out all the financing transactions needed in order to comply with the principal and interest payment obligations before the BH and CH holders. The creditor will subrogate to the latter’s position.
Finally, Law 41/2007 introduces some amendments that, although in most cases are aimed at clarifying the current rules, sometimes entail a complete novelty with respect to the system in force:
1. The categories of entities qualified to issue mortgage securities have been updated. The list included in Law 2/1981 was outdated, and now includes: banks, official credit entities (“entidades oficiales de crédito”) when so permitted by their articles of association, savings banks (“cajas de ahorro”), the Spanish Savings Banks Confederation (“Confederación Española de Cajas de Ahorros”), credit cooperatives (“cooperativas de crédito”), and financial credit entities (“establecimientos financieros de crédito”). Even though Law 41/2007 remains silent as to whether or not foreign credit entities providing services in Spain through a branch are entitled to issue mortgage securities under Law 2/1981, this possibility has been acknowledged during recent months and some Spanish branches of European Union credit entities have issued mortgage securities.
2. The entities issuing CH must keep a special accounting registry of the loans and credits that secure such issuances, as well as, where applicable, the substitution assets and derivative financial instruments, where those loans and credits complying with the eligibility criteria must be identified for purposes of the CH issuance threshold. This provision clarifies that all mortgage loans and credits included in the issuer’s portfolio (i.e., eligible and non-eligible) secure the issuance of CH, the eligibility criteria being relevant for purposes of calculating the 80% threshold (see section 2.3). The entities issuing BH must keep a similar registry, although it need only contain the mortgage loans and credits, and, where applicable, the substitution assets and derivative financial instruments relating to each issue.
3. Law 41/2007 has clarified that all CH investors hold the same rank over the secured assets, irrespective of the CH issue date.