Security over book debts/receivables: Spain
2006 IBA Banking Law Newsletter, n.º 1
As a general principle, Article 1,911 of the Spanish Civil Code sets forth that debtors are liable for complying with their obligations with all their present and future assets. Leaving aside this personal liability of the debtor, the creditor may seek additional protection against a default obtaining guarantees. Similarly to other jurisdictions, a basic distinction is made under Spanish law between in personam guarantees (garantías personales), where the creditor is entitled to request payment from a third party, different from the debtor, that guarantees the obligations of the latter, and in rem guarantees (garantías reales), which are rights created upon certain assets, owned by the debtor or a third party, which allow creditors to enforce their credit rights against those assets with priority over other creditors.
The most relevant features common to all types of in rem guarantees or security interests under Spanish law may be summarised as follows:
(i) The charged asset is “separated” and “reserved” for the benefit of a certain creditor.
(ii) A security interest is enforceable and binding vis-à-vis third parties.
(iii) Security interests secure compliance with a certain and defined obligation. Security interests are ancillary to such principal obligation and cannot exist without it.
(iv) As a general rule, Spanish law prevents any form of foreclosure of a security interest allowing direct and immediate appropriation of the secured asset by the holder of the credit. In case of a breach of the secured obligation, the creditor must foreclose the security interest. Foreclosure normally involves a judicial or non-judicial procedure aimed at selling the relevant asset in a public auction, discharging the secured obligation with the proceeds from the sale and, if any, returning the excess to the owner of the asset.
Originally, the Civil Code established two types of security interests: (a) the pledge (prenda), a security interest suitable for movable assets, which requires the mandatory transfer of possession of the relevant asset from the debtor (or owner of the asset) to the secured creditor, and (b) the mortgage (hipoteca), a security interest created on real estate assets, where no transfer of possession is necessary as the registration of the mortgage with the Property Registry (Registro de la Propiedad) allows any third party to be aware that a particular asset is mortgaged.
Subsequently, the deficiencies inherent to the traditional types of security interests (in the case of a pledge, for example, the creditor’s appropriation of the pledged asset could prevent the debtor from generating significant income which would ultimately allow repayment of the secured debt) have resulted into the creation of new kinds of security interests which rely on other procedures to guarantee the public knowledge of the security interest without limiting the debtor’s ability to use the relevant asset.
Within this framework, the Civil Code does not make any reference to the possibility to create a security interest over credit rights. In absence of specific rules allowing or denying this possibility, this matter has been subject to extensive discussion in the past because, in fact, the practical importance of such instrument cannot be ignored in the financial scenario. However, one specific premise was clear: that the regime applicable to the pledges of tangible assets could not be used for intangible assets and, in particular, credit rights by simple extension of the provisions applicable to the former. As mentioned above, perfection of a pledge on a tangible asset requires the transfer of possession and, by definition, credit rights are not capable of being possessed. In this regard, the transfer of underlying documents evidencing the existence of the credit right, such as invoices, may not be deemed a transfer of possession of the credit right itself.
In view of the above, two basic alternatives seemed available: to accept the pledge of credit rights simply as a valid source of obligations for the parties to the pledge agreement without effects vis-à-vis third parties or, alternatively, to accept the possibility to create a pledge on credit rights as a valid security interest applying to the extent possible the rules existing on pledges over tangible assets and the assignment of credits. The first alternative did not receive significant backing among scholars but was, nevertheless, substantially accepted by the Supreme Court from 1985 to 1997. The second alternative has prevailed, though.
2. Formation and perfection of the pledge
As advanced, from 1985 to 1997, Supreme Court decisions did not question the inter partes validity of the pledge contract. During this period, the case law evolved from a thesis originally contrary to the validity of the pledge over credit rights to a stage in which the possibility of constituting such a pledge was accepted from a formal point of view but its effects against third parties were deemed to begin on the date on which the creditor finally calculated the amount due by the debtor (usually upon default) thereby limiting in practice the possibility to rank senior to other creditors.
A pathbreaking case was decided by the Supreme Court on 19 April 1997 and subsequently confirmed by another decision of 7 October 1997. In the first decision, the question, discussed in the context of a dispute between an airline, Hispania Líneas Aéreas, S.A and a Spanish bank, the Banco Exterior de España, S.A., was whether a fixed-term deposit of the airline in the bank, which was pledged to secure debts of the company towards the bank, could be foreclosed by its own terms or had to be included in the bankruptcy estate of the airline. In this case, the Supreme Court recognised the validity of a pledge over banking deposits as a pledge created not over the cash deposited but over the right to recover such cash from the bank, granted to that pledge priority over other charges created over the same right after the pledge, accepted the notification of the pledge to the debtor as equivalent to the transfer of possession and, finally, stated that this type of pledge was suitable to be enforced through set-off. This was further reinforced by a Supreme Court decision of 13 November 1999 which, in addition, recognised the privilege of the pledge over a third party’s claim in those cases where the credit secured by a pledge was still contingent at the moment of the third party’s claim and arose afterwards, thereby accepting the validity of the pledges over credit rights created to secure future and contingent obligations.
Prior to these decisions of the Supreme Court, there had been some voices in favour of the understanding that a public deed should not be required to create a pledge over credits and that notification to the debtor was not mandatory.
The controversy about the need to formalise the pledge agreement in a public deed arose from the extension of the rules on the assignment of credits to the pledges over credit rights. Credit rights may be transferred under Spanish law pursuant to an agreement executed by the assignor and the assignee that does not need to be formalised in a deed, although the transfer is effective vis-à-vis third parties once its date may be considered certain (the notary formalising a deed certifies the date so that, from a practical point of view, assignments of credit rights are mostly formalised in deeds). Based on these rules, it was argued that the creation of a pledge was less traumatic to the credit right than its sale, so that if there was no need to execute a deed in the case of a sale this formality should not be required for the creation of the pledge. However, the Civil Code generally requires the formalisation of the pledge agreement in a deed, together with the transfer of the possession of the charged asset, as a requisite for perfection of the security interest. Furthermore, the argument based on the extension of the rules on the assignment of credit rights may not be sustained: real estate may be sold without the need to formalise the sale and purchase agreement in a deed but a mortgage has to be compulsorily created in a public deed.
With respect to the notification to the debtor and the position defended by the Supreme Court that identifies such notice with the required transfer of possession, there are perhaps more reasons to criticise it. Transfer of possession serves the purpose of alerting other creditors about the creation of the security interest, whereas the notice to the debtor, although it has an undoubted practical interest since it ensures that the credit right will be paid to the creditor benefiting from the pledge, will hardly achieve the same goal.
In any event, these matters have been consistently reaffirmed by the case law and, although still discussed among scholars, the formalisation of the pledge agreement in a deed and the notification to the debtor are always complied with in practice.
3. Pledge over future credit rights
Identification of the asset given as a collateral is key for the valid creation of security interests under Spanish law. In the case of credit rights, however, the precise identification of the credit rights, which continuously arise and are paid, may potentially generate significant difficulties to the operation of these pledges in the market, particularly if it is understood that the pledged credit rights have to be identified once they are created thereby requiring the pledgor and the pledgee to execute pledge agreements from time to time.
The Third Additional Provision of the former Act on Venture Capital Entities, which remain in force, is applicable to the assignment of credits and thought to regulate factoring activities. These provisions foresee the possibility of the parties agreeing on the assignment of credits that are not completely identified at the moment of the execution of the assignment because they will arise in the future. In this case, assignment is effected through an umbrella agreement, a sole and consolidated contract, that identifies the credit rights with reference to (a) the period of time when they may arise (up to a year from the date of the agreement), (b) the debtor or (c) the specific legal relationship that gives cause to such credits.
The underlying rationale of this solution is to allow the functioning of financial markets without the barriers that have usually been related to the assignment of credit rights ensuring future credit rights may be assigned under a single assignment agreement formalised in a public deed. It seems reasonable to apply this solution to the pledge of credit rights because by definition as mentioned above, such pledges are deemed to be less traumatic to the credit than the assignment itself. In practice, pledges over future credit rights are created through a single deed but identifying the pledged credit rights in accordance with the rules mentioned above.
4. Set off of debts against the proceeds of the pledge
Questions have been made about whether the set-off of the secured credits with the proceeds of the pledge is possible, or whether it violates the rule that a creditor cannot appropriate the pledged asset directly.
The ordinary proceeding for the enforcement of a pledge is by way of auction. Such an enforcement proceeding would in the case of pledges over credit rights merely bring transaction costs to the parties while significantly increasing inefficiencies in the market.
In contrast, the nature of the pledged asset allows creditors to directly access the underlying funds as the credits are paid, without further risks of defrauding the credit, as it has an evident and determined face value. Also, it is in the interest of the debtor that an eventual enforcement of the collateral is facilitated, provided no dispute may arise as to the value of the credit right, causing such collateral to be more tradable and accepted in the market, and, as a result, enabling the debtor to obtain credit under more favourable conditions.
In view of the above, reconciling the operation of the market with the interest of the parties involved in the transaction demands pacific acceptance of the set-off of credit rights as the proceeding for enforcement of these pledges. Set-off, in this context, implies payment of the credit right to the creditor upon default followed by direct retention of the due amount paid and return of the exceeding amount to the debtor, if any.
Spanish courts have confirmed the possibility of set-off as enforcement proceeding for pledges over credit rights. Moreover, as set-off in this context is merely an enforcement of the pledge, it should not be interfered by claims of other creditors against the secured debtor, even in a bankruptcy proceeding where set-off is not generally allowed.
5. Ranking in a winding up
The Insolvency Act, which entered into force on 1 September 2004, expressly mentions that a security interest over credit rights ranks with priority in the context of a bankruptcy in those cases where such a security interest has been formalised in a public deed.
Therefore, a credit secured by a pledge over credit rights is considered, pursuant to the Insolvency Act, a credit with a special privilege. Credit rights that benefit from a special privilege are paid out of the charged asset with priority over the remaining creditors of the insolvent debtor.
Spanish banking practice has adopted the pledges over credit rights as a usual type of collateral. They represent a demand of the financial markets and also a mean of providing credit to companies, that have typically made use of this alternative to facilitate the funding of their business activities.
In view of this practical relevance, the historical debate over the classification and regulation of this category of security interests arising as a result of the legal omissions and case law tradition is gradually losing its importance. The trend consists on the consolidation of this model with basis on the market’s needs and interests, therefore allowing fully operation of the mechanism and an efficient development of the Spanish banking market.
In practice, the creation of pledges over credit rights is common and is effected through the formalisation of a pledge agreement in a public deed and the notification of the pledge to the relevant debtors. In case of default, enforcement is channelled through the set-off of the secured obligation with the funds obtained upon payment of the charged credit rights.