5 September 2022
When providing a secured loan a lender may take security from parties other than its borrower to limit its credit risk, for example, from an affiliate of or investor in the borrower. Such third-party security could take the form of a guarantee, surety or declaration of joint and several liability or a third-party could provide a mortgage or pledge over an asset belonging to it to secure the debt of the borrower. If a third-party security provider partially or fully discharges a borrower's debt to the lender, whether by payment or through enforcement by the lender of its third-party security, the third-party security provider will, by operation of law, immediately obtain a right to claim the amount discharged by it back from the borrower based on recourse (regres) and subrogation (subrogatie).
These rights of recourse are not very desirable for a lender if the borrower still owes the lender money as well. Claims made against its borrower by a third-party security provider will compete with the lender’s own claims, could push the lender's loan into default and could interfere with a lender’s own strategy in a loan default scenario. In a worst case scenario, a third-party security provider may push a borrower into bankruptcy or creditor scheme of arrangement proceedings, which could seriously affect a lender’s potential to have further recourse against the borrower.
For these reasons and because there is, as we will see, no one size fits all solution for this issue, various provisions are usually included in loan agreements and security documents to prevent or limit risks posed to a lender by recourse and subrogation claims from third-party security providers. In this blog we will briefly discuss the difference between recourse and subrogation claims and the pros and cons of the different provisions used in practice to prevent such claims from becoming effective or mitigate their impact on the interests of a lender.
Recourse and subrogation claims, what is the difference and does it matter?
Pursuant to the Dutch Civil Code, a third-party security provider who has paid a borrower’s debt (regardless of whether this was done through an actual payment, set-off or a lender enforcing and having recourse against third-party security provided by it) obtains an own claim of recourse (regresvordering) against the borrower for the amount paid by it. In addition, the lender’s claim will, upon the third-party security provider’s payment and up to the amount paid by it, be transferred to the third-party security provider by operation of law. The third-party security provider then has the choice to have recourse against the borrower on the basis of its own claim of recourse or on the basis of the lender’s claim as transferred to it through subrogation or, to the extent the two do not overlap, both.
The main advantage of an own recourse claim over a subrogated claim in practical terms is that a recourse claim also gives the third-party security provider the right to claim back costs it may have incurred in connection with the payment by it of the borrower’s debt, such as collection and security enforcement costs claimed from the third-party security provider by the lender or costs made by it in connection with any legal proceedings around the existence, amount and further scope of the claim discharged by it to the lender.
As opposed to a recourse claim, a subrogated claim will, however, give the subrogated third-party security provider a right to any further security provided for the lender’s claims to which it has become entitled through subrogation. If the lender itself has not been discharged in full, the third-party security provider will obtain a shared right with the lender to such security pro rata to its and the lender’s claims secured by that security. For a lender this is particularly unattractive, because such jointly held security will, if in the form of a Dutch law mortgage or pledge, from that moment qualify as joint property under the Dutch Civil Code. The latter arguably entails that the lender can, pursuant to mandatory Dutch law statutory rules on disposals of joint property then becoming applicable to such security, no longer enforce its security without the co-operation of its co-owner, the third-party security provider. The latter will often be an affiliate of or investor in the borrower with its own interests and agenda, especially in a borrower enforcement/insolvency scenario which is not very helpful for a lender.
Although such considerations are not exclusively an issue for commercial real estate loans, they do bite all the more where, as is usually the case with commercial real estate loans, a lender’s recourse is limited to the assets financed by it and the security provided to it over such assets.
Provisions used in practice to avoid/mitigate impact from recourse/subrogation claims of third-party security providers
In practice, lenders use various provisions to get rid of possible intervening recourse and subrogation claims of third-party security providers. In the below schematic overview, the pros and cons of the most usual provisions are briefly discussed. The below leaves aside defenses and legal restrictions that may apply to such provisions and, for that matter, third-party security in general, such as the question as to whether such provisions or even the third-party security itself might be capable of being avoided on the basis of ultra vires restrictions/lack of sufficient corporate benefit on the part of the third-party security provider. It should be noted though that corporate benefit issues may need to be looked into depending on the context of the transaction and security provided and may become more of an issue in cases where a third-party security provider is required to give up its recourse and subrogation claims permanently, also after the lender has been discharged in full.
In addition, where guarantees are concerned, lenders may try to either document these as so-called abstract guarantees or require that the intended guarantor becomes a party to the loan agreement as a jointly and severally liable co-borrower. In the case of an abstract guarantee, the guarantee should provide that the third-party (guarantor) guarantees the borrower’s debt to the lender by way of an own independent obligation. Where this is done, the guarantor will not obtain a recourse claim or subrogate in the lender’s claims against the Borrower upon payment under its guarantee. A jointly and severally liable co-borrower will have a recourse or subrogated claim against the (actual) borrower to the extent it makes a payment to the lender with respect to any amount that it did not (directly or indirectly) borrowed itself.
| Provision | Advantages | Disadvantages | |
| 1. |
Waiver Sometimes made subject to a condition subsequent (ontbindende voorwaarde) to the effect that the third -party security provider’s rights will revive upon lender having been discharged in full or combined with a replacement contractually agreed right of compensation of the third -party security provider to be compensated by the borrower (Contractual Right of Recourse), which right is then pledged to the lender and subordinated. Care must be taken with these provisions if combined with security over shares or equivalent in the borrower. In a share enforcement scenario whereby the lender is discharged, these provisions could lead to a buyer of the shares being confronted with a revival of recourse claims from third-party security providers, typically ex-affiliates of or ex-investors in the company (borrower) bought by it. |
Nice and clean, no recourse or subrogation claims will arise. |
Not effective if payment is obtained from the third-party security provider and recourse and subrogation claims arise after the third-party security provider has been declared bankrupt (failliet) or become subject to a moratorium (surséance van betaling). The third-party security provider will at that time under Dutch law lack the power of disposal necessary to provide an effective waiver of such claims when these arise.
As opposed to pledging, no remaining security value for lender if recourse and subrogated claims are waived rather than pledged to the lender. |
| 2. |
Pledge |
Lender can take control over recourse and subrogation claims and take the benefit of the potential additional security value these may have for it. It can collect the relevant claims and sell these in an enforcement scenario. It can also exercise voting rights relating to such claims if the borrower becomes subject to court approved creditor scheme of arrangement proceedings (WHOA procedure). As opposed to mere contractual provisions, a pledge can be invoked against any party, including a party that might have made an attachment with respect to the pledged claims. |
Same as for 1 (not effective on bankruptcy of moratorium of the third-party security provider). |
| 3. |
Contractual provision that no recourse claims will arise and no subrogation will take place until lender has been irrevocably and unconditionally discharged in full. |
More borrower friendly than a definitive waiver. |
Arguably not valid on the basis that a recourse claim or subrogation of claims becomes effective and payable by operation of law and this can therefore not be postponed by contractual arrangement. An alternative to resolve this could be to include a provision to the effect that the statutory provisions providing a third-party security provider with recourse and subrogation claims do not apply, on the basis that these statutory provisions are not mandatory law allowing parties to divert from these by contractual arrangement. Instead, a Contractual Right of Recourse could then be agreed subject to the provision that this only becomes effective upon full discharge of the lender. It is generally accepted that it is possible for parties to agree this with respect to a Contractual Right of Recourse. |
| 4. |
Contractual provision that recourse and subrogation claims will not become due and payable until lender has been irrevocably and unconditionally discharged in full . Same issue as for 3 regarding Dutch courts’ interpretation of such a provision. |
Same as for 3. |
Same as for 3, but arguably less of an issue on the basis that where the law provides for an immediately due and payable claim, parties can still agree that a claim will upon coming into existence/being obtained not/no longer be due and payable until another debt has been discharged.
The third-party security provider will still obtain recourse and subrogation claims even if not (yet) due and payable. Impact of what this means in terms of sharing in lender’s security for subrogated claims for which security was provided (see above on joint property statutory provision related issues with this) is unclear. Third-party security provider could, with the support of an additional due and payable claim, use its recourse and subrogation claims to submit a request for the bankruptcy of the borrower and vote for a creditor arrangement which opposes the lender’s strategy in the context of court approved creditor scheme of arrangement provisions. These issues can to an extent be resolved by further contractual restrictions coupled with a power of attorney and mandate to the lender to take decisions on the enforcement of jointly held security and vote in the context of creditor scheme of arrangement proceedings on behalf of the relevant third-party security provider, but any such power of attorney/mandate will lapse on bankruptcy of the third-party security provider and no longer be effective on it becoming subject to a moratorium |
| 5. |
Contractual subordination of recourse and subrogation claims to lender’s claims. |
Same as for 3. but cannot be invoked against third parties. |
Contractual arrangement only and can therefore not be invoked against third parties. Third-party security provider will still obtain recourse and subrogation claims resulting in similar issues as noted above under 4. |
The above chart shows that there is no single ideal solution. Usually, a combination of the above provisions will be used.
Arguably, a combination of options 1 up to and including 5 of the above table, whereby other options apply to the extent that a waiver (option 1) is not effective or considered too borrower unfriendly is the best solution, because options 1 and 2 are powerful and clean ways to avoid recourse and subrogation claims outside a situation of bankruptcy or moratorium of the third party security provider or ensure that these are within the lender's control, whilst options 3 through 5 are useful supplements for cases where other options, in particular 1 and 2, prove to be ineffective. The different options can thus complement each other when necessary and, unsurprisingly, general market practice is therefore also to combine them, in sometimes somewhat different ways, depending on the deal.
In any case, although it is true that lenders’ and their risk committees should be able to leave the details to their lawyers, it is good to realise that third party security may have implications that should be considered by them and their lawyers jointly in order to properly assess the potential impact of recourse and subrogation claims and, especially where provisions around this are being negotiated by borrowerside, reach a position that is acceptable to the lender from a risk/exit strategy perspective in a potential borrower (group) default/enforcement and insolvency scenario.
