New Rules on Enforcing Pledges and Mortgages

March 2009

Since Russia has been affected by the worldwide credit crunch, more attention is being paid to the rights of creditors and means of securing the performance of financial obligations. Correspondingly, in January 2009, amendments to Russian legislation on pledges and mortgages (the "Amendments") introduced substantial reforms in enforcement procedures, and eliminated certain gaps and inconsistencies in the prior rules. Key developments in this area are summarized below.

Non-Judicial Enforcement Procedures

Agreements for "Out-of-Court" Enforcement

Prior to the Amendments, Russian law already provided the possibility of non-judicial enforcement procedures in connection with a pledge of assets ('zalog dvizhimogo imuschestva') or mortgage over property ('zalog nedvizhimogo imuschestva' or 'ipoteka'). In theory, these procedures allowed creditors to foreclose upon collateral without applying to the Russian courts. However, such procedures were not widely used in practice, in part because there was only a limited ability to agree on out-of-court procedures prior to default under the Mortgage Law, and the rules were unclear under the laws governing pledges of movable property. Now, as a result of the Amendments, it is possible for secured lenders and borrowers to agree on out-of-court enforcement procedures at any point during the term of the transaction by including the appropriate language in the legal documentation.

Simplified Foreclosure Procedure

The Amendments also introduce a simplified procedure where the parties have agreed to "out-of-court" enforcement. If the pledgor fails to cooperate with foreclosure, the pledgee may obtain a special instrument from a notary, called an "execution order" ('ispolnitel'naya nadpis' notariusa'), subject to the delivery of certain documents to the notary and compliance with specific procedures. An execution order entitles the pledgee to seize the pledged or mortgaged collateral with the direct assistance of court bailiffs, and without recourse to the courts.

Limitations

Whilst the Amendments generally aim to encourage the use of out-of-court enforcement procedures, they have also expanded the list of cases in which such procedures are prohibited. For example, only judicial foreclosure is now available in connection with residential housing mortgages and mortgages of state or municipal property.

Under the Amendments, notarization is always required for agreements that allow non-judicial foreclosure with respect to any assets pledged by an individual or any mortgaged property.

Details of Non-Judicial Enforcement Procedures

Foreclosure on Pledged Assets

New non-judicial foreclosure methods are now expressly allowed. In addition to the existing procedure for foreclosure by means of sale of the collateral at a public auction, the parties may also agree on sale by a third-party, the "commission agent" (who may be specified in the agreement or selected by the pledgee in its discretion).

Further, where a pledge agreement is entered into among legal entities and "individual entrepreneurs" (i.e., individuals who are registered with the tax authorities as conducting their own businesses) to secure obligations arising from commercial activity, the parties may agree on any of the following foreclosure methods: (i) direct transfer of the collateral to the pledgee, or (ii) sale of the collateral by the pledgee to a third party - whether under a "commission agency agreement" or otherwise - without a public auction.

The new out-of-court foreclosure methods also contemplate that under certain circumstances; the collateral may be sold or transferred at fair market value as determined by an independent appraiser (as opposed to the sale of collateral at a public auction, where the law permits the initial sale price to be less than fair market value). It is unclear how the appraisals will work in practice and whether the appraisal requirement will become another practical obstacle to rapid and efficient enforcement (since for example, debtors may challenge the appraised value in the courts).

Foreclosure on Publicly Traded Securities

Under the Amendments, non-judicial foreclosure on securities traded through stock exchanges or other trading platforms ("publicly traded securities") should be conducted by way of sale during a trading session. The law is not clear as to whether certain of the out-of-court methods described above (such as the direct transfer of the collateral to the pledgee) are available in respect of publicly traded securities. 

Other Important Developments

Involvement of Independent Appraisers

Pursuant to the Amendments, agreements for non-judicial foreclosure may state the price at which the collateral should be offered for sale or retained by the pledgee, or the method for the calculation of such price. However, with respect to certain categories of assets - including, inter alia, property whose value exceeds 500,000 Rubles (approximately $14,000),[1]and securities that are not publicly traded - the sale price should be based on fair market value as confirmed by an independent appraisal.

Timing

The Amendments have eliminated several ambiguities relating to the timing of foreclosure proceedings. Unless the parties have agreed on a longer period, the pledgee may enforce the pledge upon the earlier of: (i) ten days following the pledgor's receipt of an enforcement notice from the pledgee, or (ii) 45 days after service of the enforcement notice by the pledgee or the arranger of a public auction. These notice periods may be shortened if there is a material risk that the collateral may be lost or damaged, or that its value would be significantly reduced below the initial sale price specified in the notice.

Deferral or Denial of Enforcement

Under the Amendments, the Russian courts may not delay the commencement of non-judicial foreclosure proceedings. Conversely, courts retain the right to "defer" judicial enforcement for up to one year, depending on the circumstances.

Under prior law, foreclosure could also be avoided if the debtor's default was not "material," and as a consequence the amount of the claim was clearly disproportional to the value of the collateral. The concept of "material" was not further defined. The Amendments now directly prohibit foreclosure in case of a non-"material" default and provide for materiality criteria: unless proved otherwise, a default is deemed not to be material and a claim is treated as clearly disproportional to the value of the collateral, if both of the following conditions are met:

(i)         The value of the claim is less than 5 percent of the value of the collateral, as determined under the terms of the security documentation; and

(ii)         The delay in performance of the secured obligations has not exceeded three months.

The Amendments also impose special rules for periodic payments, such as installment and interest payments. In such cases, the pledgee may only foreclose if the breach of obligations is "systematic," unless the applicable pledge agreement or mortgage provides otherwise. A "systematic" breach will be deemed to occur if such payments are delinquent more than three times during any 12-month period (even if the amount of any single breach is not "material").

Subsequent Pledges

The Amendments have also clarified the rights of secured creditors with different ranking pledges. Generally, a first-ranking pledgee may foreclose on the collateral as soon as a lower-ranking pledgee commences foreclosure, even if the debtor has not defaulted on the obligations owed to the first-ranking creditor (in effect, creating a statutory cross-default provision). If the first-ranking creditor does not foreclose for some reason, its pledge rights will remain in effect. (A corresponding provision has long existed in the Mortgage Law, but nonetheless remains largely untested in the courts.)

Mortgage Certificates

The provisions of the Mortgage Law relating to mortgage certificates ('zakladnaya') have undergone a number of technical revisions. Notably, the Amendments allow the rights to mortgage certificates to be recorded with licensed, third-party depositories (similar to the existing system for shares and bonds), thus simplifying transactions with mortgage certificates.

Rights of Secured Creditors in Bankruptcy

Impact of Insolvency on Enforcement

Pursuant to the Amendments, non-judicial foreclosure will no longer be available upon the commencement of bankruptcy proceedings. Thereafter, any foreclosure must be pursued through the court which oversees the bankruptcy, and only after the initial stage of bankruptcy (known as "supervision" or 'nablyudeniye'). However, the court has discretion to refuse foreclosure if this would prevent the debtor from being capable of returning to solvency. (We anticipate that this issue may be extensively litigated.)

Voting Rights of Secured Creditors

The amended Bankruptcy Law allows creditors whose claims are secured by a pledge of movable property or mortgage to be present during formal creditors' meetings at any stage of a Russian bankruptcy proceeding. However, such creditors only have voting rights in the initial stage (supervision). In later stages of the proceedings (such as "financial rehabilitation" and "external management," where applicable), secured creditors will have voting rights only if they have sought to foreclose on the collateral, and the court overseeing the bankruptcy has denied enforcement, or if the creditor has waived its rights to enforce the security.

Allocation of Proceeds

Under the Amendments, new rules apply to the allocation of proceeds from the sale of collateral in bankruptcy proceedings. These should be distributed as follows:

(i)         The secured creditor receives the lesser of (a) 70 percent of the gross proceeds (80 percent for bank or other financial creditors enforcing loan agreements), or (b) the full amount of the outstanding principal and interest;

(ii)        Thirty percent of the gross proceeds (20 percent for bank or other financial creditors) are transferred to a special bank account of the debtor and applied as follows:

   (a)        Two-thirds of this amount (i.e., 20 percent of the gross proceeds) are paid to employees and individuals with salary and health claims, if the debtor's other assets are insufficient to satisfy such claims (or 15 percent of the gross proceeds in the case of bank or other financial creditors). Any funds remaining revert to the relevant secured creditor, and after the debt is satisfied in full, any balance is included in the general bankruptcy estate of the debtor; and

   (b)        Ten percent of the gross proceeds are used to pay the court-appointed trustee (called an "arbitration manager") and for other court-related costs (or 5 percent of gross proceeds in the case of bank or other financial creditors).