Mortgages Get a Lease of Life

Fernando Azofra, Agustín Redondo Aparicio.

September 2006 International Financial Law Review


Introduction

Some recent decisions of the Spanish General Directorate of Land Registries and Notaries [1]  (using its Spanish acronym, “DGRN”) have confirmed the possibility of registering conditional mortgages in Spanish land registries. These decisions are likely to encourage the use of this type of security. Up to now, only high-profile players have used conditional mortgages in the field of project and real estate finance.

From the wide range of security interests offered by Spanish law to finance transactions, mortgages are undoubtedly the preferred and most commonly used security interest. However, Spanish mortgages are expensive in contrast to other jurisdictions. In addition to notarial and registration fees, a mortgage is subject to a 0.5%-1% stamp duty which is also levied on the total amount secured by the mortgage (principal, ordinary interest, default interest, fees and expenses, etc.). Thus, the total cost of the mortgage could easily range between 1% and 1.5% of the loan or credit facility principal. Moreover, these taxes may accrue again when assigning security interests, during a syndication process or if there are changes in the banking syndicate.

Spanish law and practice have traditionally followed an extremely formalistic approach when it comes to creating and enforcing security interests, and the registration of mortgages at the land registry is a requisite of their validity. Therefore, the decision of the General Directorate is particularly significant, as it secures the possibility of registration and confirms the use of an alternative structure to provide security for financing transactions in Spain.

Alternative mortgage-backed structures

Lenders have not been oblivious to the high cost of mortgages, especially in a mature and highly competitive market such as the Spanish in recent years. Until the tax authorities closed the loop, unilateral mortgages were widely used. In view of this new scenario, financing parties seeking to provide the most cost-efficient and competitive offers started using other instruments. These structures entail certain risks and limitations, especially with regard to their securitization.

One of the most common instruments was the use of mortgage promises, either for the total amount of the facility or combining the creation of a standard mortgage securing a portion of the facility, with a promise to create a mortgage to secure an additional portion . The promise was contained in a public deed and in turn secured by an irrevocable notarised power of attorney granted in favour of the lender. However, the implementation of a financing transaction with this structure poses important drawbacks. A promise to create a mortgage only gives rise to a personal right or claim enforceable against the borrower, not an in rem right, thus, the mortgagees fail to benefit from the priority ranking established under Spanish law against other creditors. The promise will not rank ahead of any other liens or encumbrances (e.g., other later mortgages and attachments) created over the asset, whilst the promise is yet to be fulfilled. Moreover, the borrower may be tempted to question the validity or enforceability of the promise to mortgage and the irrevocable nature of the power of attorney, despite the fact that recent case law has endorsed the validity and irrevocability of these powers of attorney.

Another instrument used to minimise the tax cost has been to limit the total secured amount (the basis used for calculating the tax applicable to the mortgage) to the principal amount, or capping them. As obvious drawback, interest and expenses not included or caped shall not be secured by the mortgage.

Conditional mortgages

Another alternative which was sometimes used, especially in recent years, was the creation of a mortgage (or an increase in the amount secured by a conventional mortgage) conditional upon the fulfilment of certain conditions precedent.

A conditional mortgage provides that a mortgage itself (or the extension of the maximum amount secured under the mortgage) will only become effective if and when certain objective and previously determined events occur. Only when the condition precedents are satisfied, will the mortgage be created or extended (and therefore be extendable) and the relevant stamp duty levied on the (increased) amount secured. The conditional mortgage must be recorded at the Land Registry at the outset of the transaction, in order to be entitled to the privileges awarded by the Land Registry.

Conditions precedent eligible to be recorded must fulfil certain requirements. Some of them are common to all conditions precedent under Spanish law: they must not be dependant on the will of either of the parties, they must be realistic, objective and clearly set forth and they must be particularly relevant for the business in question. Others are specific for this structure: the terms and conditions applied in conditional mortgages must refer to factual events or circumstances (conditio facti), as opposed to legal aspects (conditio iuris) of the mortgage such as the lack of repayment of the facility or other similar events of default. This means that default is not acceptable as a condition precedent, but others such as a decrease in the value of the facility or certain financial ratios, such as LTV, DSCR, etc. (provided always that these ratio triggers are different to the ones qualifying as events of default or early termination events under the facility). The relevant deed must set forth appropriate mechanisms to provide evidence of compliance of the conditions precedent for the land registry (if possible, a mechanism that does not require any action from the borrower).

The main advantages of the use of conditional mortgages compared to mortgage promises and other structures is that conditional mortgages, once registered, will become fully enforceable vis-à-vis third parties upon satisfaction of the conditions precedents. The effects of the mortgage vis-à-vis third parties shall be retroacted to the date of recording at the relevant land registry and shall create a privileged security right over the asset enforceable against any third party, as well as ranking ahead of any mortgage or encumbrance filed at the land registry after the first registration of the conditional mortgage. In addition, conditional mortgages do not trigger any stamp duty until the relevant condition(s) precedent is/are fulfilled.

However, it is essential to highlight that the lender will not be entitled to foreclose on the conditional mortgage whilst being conditional (i.e., until any of the condition precedents are fulfilled and evidence thereof is registered at the Land Registry), even in the event of default of the borrower’s secured obligations under the relevant facility.

DGRN resolutions

Although conditional mortgages are expressly recognised in some jurisdictions, Spanish law did not foresee them specifically. Given the novelty of this structure, registrars had been reluctant to accept the use of conditional mortgages. Land registrars were concerned about their impact on the transfer of real estate assets, in particular, common real estate assets, such as dwellings, if the structure was to be widely used by mortgage banks. Although registrars were increasingly accepting the registration of conditional mortgages for sophisticated transactions before these resolutions of the DGRN were issued, the acceptance very often required the relevant registrar’s non-binding sign-off before the execution of any conditional mortgage and additional work.

Therefore, the resolutions of the DGRN confirming the possibility of registration of the conditional mortgages are essential to ensure the future of this type of mortgages, as they will provide an appropriate level of security which is essential in any kind of security. Moreover, the resolutions of the DGRN have confirmed the acceptance of some of the most commonly used types of conditions precedent, such as the breach of certain financial covenants (i.e., ICR, DSCR and LTV among others) not qualifying as events of default under the facility, or the reduction of the net profits generated by the mortgaged asset under certain thresholds.

In any event, given the complexity of this kind of structure and the somewhat reduced level of protection afforded to the lender, this structure should not be applied outside the scope of major transactions where the benefits outweigh the potential risks assumed.


[1]           Resolutions dated September 2 and 3, 2005, published in the Official Gazette of October 19 and 20, 2006.