In a recent case (the “Bowie Recycling Case”) the Dutch Supreme Court has finally confirmed that it is possible to change the priority of an existing right of pledge versus one or more other rights of pledge over the same assets in a similar way as already expressly provided for in relation to rights of mortgage under the Dutch Civil Code. Prior to this, there was no clear legal basis to rearrange the priority of rights of pledge, leading parties to resort to contractual intercreditor arrangements or recreation of pledges in the intended order of priority to achieve the same result to, for example, allow for a secured mezzanine loan or to give priority security to a lender providing additional financing in a restructuring situation. Furthermore, the Dutch Supreme Court has provided new and useful guidance with respect to the rules that apply to collection of pledged receivables and distribution of proceeds in cases where a claim secured by a pledge over rights and receivables is itself pledged by the original creditor/pledgee to another creditor, which could for example be done in the context of a loan-on-loan transaction.
In this blog we briefly discuss the practical implications of the Bowie Recycling Case.
Changing the priority of rights of pledge
Under Dutch law rights of pledge will take priority in the chronological order in which these have been created. An exception may apply where a subsequent pledgee was unaware that the asset was already encumbered with another pledge, however, in practical terms, this exception does not apply to pledged rights and receivables (unless these are embodied in securities).
Because there was no clear legal basis allowing parties to divert from this rule, parties would either rearrange priorities through contractual intercreditor arrangements, with the disadvantage that such arrangements would be impacted on insolvency of the, according to the order of creation, prior ranking pledgee. In that event, the intended but not quite higher ranking pledgee could end up with an unsecured claim against the formally prior ranking pledgee’s bankrupt estate. Alternatively, parties could play a game of musical chairs, rearranging their priorities by releasing their existing pledges and then re-creating them in the desired order. This could make older rights of pledge more vulnerable to fraudulent preference claims on insolvency of the pledgor. Furthermore, the pledgee whose pledge is released and recreated could thereby lose priority over other encumbrances that were created over the same assets after the creation of its original but before the vesting of its re-created right of pledge. It could also be quite a hassle, especially where undisclosed pledges over rights and receivables, such as, for example, rental income, are concerned, since these must under Dutch law be updated by supplemental pledges on a regular basis to cover new receivables arising from agreements entered into after the date on which the relevant pledges were created.
Pursuant to the Supreme Court’s decision in the Bowie Recycling Case, pledgees can now rearrange their priority vis-à-vis each other by one or multiple written agreement(s) (a private deed) and notice to the relevant debtor/counterparty of the pledged receivables/rights or, if the relevant rights of pledge are to remain undisclosed, by having the written agreement date stamped by the Dutch tax authorities. A notarial deed is not required unless the creation of the right of pledge itself is, by law, subject to the requirement of a notarial deed. This is not the case with respect to a pledge over rights and receivables, but a notarial deed is, for example, required for the creation of a pledge over registered shares in a Dutch private limited company.
This makes life a lot easier and removes the abovementioned risks. It should be noted though that, as is also the case with mortgagees that reorganise their priorities vis-à-vis each other, the basic rule of “first come, first served” will still apply in relation to third parties that have obtained an intervening interest in the pledged assets and did not agree to the rearrangement of priorities, such as a third party creditor that made an attachment with respect to the assets after the first pledge involved was created but before a subsequent pledge was created and priorities between the two were rearranged. In that case the third party creditor’s attachment would still rank before the subsequently created pledge, regardless of any priority arrangement made between the first and second pledgor to the effect that the latter would take priority over the pledge first created. In practical terms, parties will still have to rely on their debtors complying with their negative pledge covenants on this point. To further mitigate this risk, an intercreditor arrangement leading to a turnover and thereby redistribution of proceeds according to the agreed priorities between pledgees could still be considered.
Distribution of proceeds
In its decision on the Bowie Recycling Case, the Dutch Supreme Court further made clear that where a receivable is encumbered with more than one pledge, the first ranking pledgee will have the right to collect all the pledged receivables, also if these amount to more than its own secured claim. Following collection, any surplus proceeds after the first pledgee has taken its share will remain encumbered with any subsequent rights of pledge, allowing the relevant subsequent pledgees to in turn have recourse against those proceeds, after which any remaining surplus will be paid to the pledgor. Although this may seem logical, until the Dutch Supreme Court’s decision in the Bowie Recycling Case, the prevailing view was that a pledgee cannot collect pledged receivables for an amount exceeding its claims secured thereby.
This also applies in a loan-on-loan situation where a lender has granted a pledge over a loan secured by a pledge over receivables to its loan-on-loan lender. In that case, the loan-on-loan lender can collect the pledged receivables in full on the lender’s and relevant borrower’s default and have recourse against the proceeds. Any surplus proceeds would then first go to the original lender/ pledgee, after which any residual proceeds would be paid to the original pledgor.
By confirming the possibility of changing the priority of existing rights of pledge by mutual agreement (subject to, in short terms, the same formal requirements as would apply with respect to the creation of the relevant rights of pledge), the Dutch Supreme Court provided secured creditors/pledgees with the option to rearrange their priorities in a more straightforward way with minimal residual risk.
The Dutch Supreme Court has also provided welcome clarity on the rules applicable to the collection and distribution of proceeds of receivables that have been encumbered with more than one pledge.
This judgement therefore provides a welcome clarification for market parties involved in structured finance and loan-on-loan transactions, mezzanine and tranched loans and restructurings alike.