Mortgage Enforcement: New Rules and New Opportunities.


Recently, new legislation governing mortgage relations has been adopted, including on those arising from bankruptcy. The new legislation is aimed at making the mortgage creditor’s position firmer and more secure. Generally speaking, the creditor now has more rights and remedies within the enforcement procedure, while the enforcement procedure itself has become more transparent and flexible.

Potential Constraints
Due regard should, of course, be paid to the fact that the new legislation is at times controversial or unclear.  Traditionally, a more or less firm position on how to apply certain new legislative provisions can be taken only after court practice on the matter has been formed (established). This takes time as, in most cases, court practice may be deemed established only once the Supreme Arbitration Court sets its position on a particular matter.  Then one can rely on and make relatively confident forecasts of the possible outcome of a potential (or actual) dispute.

Although there is a provision according to which the new legislation is to be applied only to relations arising after its introduction, we believe this does not mean that it can serve only creditors who enter into loan agreements after the new legislation comes into force.  We are certain that some of the opportunities provided by the new legislation can be enjoyed by creditors who entered into a loan agreement before the new legislation came into force, although there is a debate in the legal doctrine as to whether the new legislation should be applied at all to such loan agreements. 

Major News for Mortgagees
Some of the major legal developments relating to mortgage enforcement are as follows. The parties to a mortgage agreement can now decide on out-of-court enforcement at any stage, i.e., even before execution of the mortgage agreement (there are certain exceptions to this rule). Such an agreement on an out-of-court procedure was previously only possible in the event of a default. This requirement meant that there was virtually no demand for this opportunity, since most mortgagors were not ready to enter into an out-of-court agreement. According to the new rules, such an agreement requires the notarised consent of the mortgagor. This consent can be built into the loan agreement or executed as a separate document. This naturally gives creditors a major chance to agree on an out-of-court procedure during negotiation of the loan, when the creditor has the most power to influence the borrower, which was not possible previously. As we mentioned, we believe that such an out-of-court agreement can be signed even for loan agreements that were entered into before the new legislation was adopted.

We have noticed that, sometimes, legal commentaries state that, in general, the New Legislation allows the parties to agree that a mortgaged property remains with the mortgagee (is to be acquired by the mortgagee directly from the mortgagor), without making any reservations. It should be stressed that no such opportunity exists with respect to land plots. This restriction is provided for explicitly in the new legislation and this should not be forgotten. Moreover, we believe that the given exemption should also apply to buildings [subject to mortgage] if they are located on a land plot owned by a mortgagor. This is not explicitly specified in the new legislation, but can be inferred from it.  The reason is that, according to the law, in cases when a building and a land plot belong to one and the same person, the building can be mortgaged (and sold, in the event of enforcement) only in conjunction with the land plot.  This compulsory combination of two facilities (land plot and building) in a single mortgage agreement means that the above exemption applies to cases when a building is located on a land plot owned by a mortgagor. We are absolutely sure that there will be court disputes over this matter. We cannot rule out the possibility that some courts will go even further and decide that the exemption also applies in cases when a building is mortgaged together with the lease rights to a land plot.

If the parties agree on an out-of-court procedure and the mortgagor does not fulfill its obligations under the agreement on the out-of-court procedure, enforcement is effectuated on the basis of a special entry made by a notary (so called “ispolnitelnaya nadpis”). It should be noted that, before making such an entry, the notary should ensure that the claim lodged against the mortgagor is undisputable, while the mortgagor has the right to argue this. If the notary has doubts, it should refuse to make a relevant entry. If that is the case, the mortgagee will have to apply to a court of law for enforcement.  We predict that there will be a significant number of disputes on this matter.

New Status of Mortgagee during Bankruptcy
Several significant improvements have been made to the legislation governing the mortgagee’s position during bankruptcy proceedings. Previously, the position of the mortgage creditor was really weak and it sometimes happened that, in the event of mortgage enforcement, such a creditor would receive a negligibly small portion of what it should have received under the loan. To generalize, we could say that, previously, a mortgage did not grant the mortgagee any really preferential position, as there are other creditors eligible to “participate” unlimitedly in such proceeds prior to the mortgagee. The new legislation has changed this fundamentally. Now mortgagees are guaranteed to receive a fixed portion of the proceeds gained as a result of sale of the mortgaged property.  For banks, this share is 80% (compared to only 70% for other lenders).  A bank might also expect to receive the remainder of the sum if certain other claims [specified in the law] do not exist or are fully satisfied.  It is now planned to amend the law to adopt the same approach to all other lenders.

It is important that in the event that a bank assigns its rights under a loan agreement to another person, the said person will also be entitled to receive 80% of the proceeds, even if it is not a bank.  This is not explicitly stated in the new legislation but follows from a systematic interpretation of the relevant provisions.

Another serious problem that existed previously was the position of a mortgagee whose mortgagor was a third person, i.e., not a debtor. Such mortgagees suffered a real risk of being left without a mortgage or money if the said mortgagor (not being a debtor under a secured obligation) underwent bankruptcy proceedings. The reason for this was that a bankruptcy creditor was defined only as a creditor having a monetary claim against the debtor undergoing bankruptcy. Since such a mortgagee did not have a direct monetary claim against the mortgagor, the mortgagee was not deemed to be a creditor for bankruptcy purposes. Furthermore, owing to certain contradictions between the main legislative acts governing enforcement and bankruptcy, it often happened that such mortgagees were not able to enforce (and/or receive satisfaction) either during the bankruptcy or in separate court proceedings. Now the situation has changed dramatically. The new legislation states explicitly that such mortgagees should be considered to be bankruptcy creditors, so their position is now much better secured and mortgage now fulfils its intended function.

The new legislation now specifies that mortgaged property should be sold only through court proceedings (even if there is an agreement between the mortgagor and the mortgagee about out-of-court enforcement) and only within a bankruptcy case (i.e., not in a separate court case).
The procedure for sale of a mortgaged property and the stages of this procedure have now become much clearer and more mortgagee-orientated. There are opportunities (although conditional) to enforce a mortgage before reaching the final stage of bankruptcy proceedings.

It is also important that it is now clear that only mortgagees in whose favor the mortgage was established can enjoy preferential satisfaction of their claims out of the proceeds from sale of property mortgaged in their favor. Mortgagees whose claims are not secured by a specific mortgaged property cannot participate in the proceeds deriving from the particular property.

Court Practice
It is worth mentioning that the Supreme Arbitration Court is making a serious effort to equip the courts with recommendations on how to apply the new legislation. Thus, in late July, the Plenary of the Supreme Arbitration Court issued Directive No. 58 “On Certain Questions Related to Satisfying the Demands of the Mortgagee during the Bankruptcy of the Mortgagor”, which provides explanations in regards to the status of the mortgagee in the bankruptcy process. These explanations are designed to help lower courts interpret the somewhat vague provisions of the new legislation, to fill in legislative gaps and provide for uniform application of the law.

Potential Difficulties and Practical Tips
There are certain challenges that the creditor might face in enforcing a mortgage.  These naturally vary from case to case and the one encountered by the creditor in a particular situation (if any) will depend on different specific circumstances, including the good faith of the mortgagor. 
It is very common (especially during the crisis) for the mortgagor to use all possible means to reject the mortgagee’s claim and block its attempt to enforce the mortgage.  Some of the most frequently used instruments are:

  • arguing the validity (legal existence) of the loan agreement secured by a mortgage or the mortgage agreement itself (mostly on the basis of absence of the requisite corporate approvals for large-scale or interested-party transactions);
  • initiating any possible counter-claim disputes in order to gain time;
  • arranging for withdrawal of the mortgaged property from the mortgagor e.g., through vindication/challenging the title to the mortgaged property – as this leads to mortgage termination;
  • and some others.

A positive factor is that Supreme Arbitration Court representatives, including its head, Mr. Ivanov, are these days constantly confirming in the press and at outside events that they will resist such attempts on the part of debtors to overcome the creditors’ claims by abusing their procedural rights. Some positive (i.e., creditor-friendly) court practice does already exist. Moreover, the Supreme Arbitration Court issued Directive No. 57 “On Certain Procedural Questions in the Practice of Reviewing Cases Related to the Failure to Fulfill or Inadequate Fulfillment of Agreement Obligations”, which provides recommendations for lower courts on dealing with such matters. Simultaneously amendments to the arbitration procedural legislation aimed at uniting such counterclaims in one court case are now developed and will soon be enacted.

A mortgagor might claim that (a) the breach is not serious (the law operates with the term “extremely insignificant”) and (b) the amount of the claim is evidently disproportionate to the value of the mortgaged property. If the court agrees that both circumstances are present, it should refuse to enforce the mortgage. The law sets a criterion for defining presence/absence of both such circumstances. Said criterion varies depending on whether the enforcement is effectuated through court proceedings or out-of-court. There is also a special rule for an obligation involving systematic payments (which applies to most loans). It should be noted that, if the court refuses to enforce a mortgage, the mortgagee will still have the right to apply for enforcement later on, when the relevant circumstances have been eliminated. There have already been quite a number of court disputes on this topic.

It should be borne in mind that the debtor under an agreement secured by mortgage or the mortgagor (if other than the debtor under the main agreement) can stop the enforcement by satisfying the mortgagee’s claims in full. This is allowed at any stage before sale of the mortgaged property.
When the creditor decides to enforce a mortgage, it is advisable to ask the court to introduce interim measures to help to preclude any unfair actions with the mortgaged property by the mortgagor. Generally speaking, the courts are reluctant to invoke interim measures, though our practice indicates that they are much more flexible when this concerns mortgage enforcement. The mortgagee should, of course, help the court to take such a decision by providing it with various data proving the risk to the mortgagee’s rights (i.e., the risk of loss of the property).

It might sound strange but mortgagees sometimes forget that, if the proceeds from sale of the mortgaged property do not suffice to satisfy the mortgagee’s claims in full, it is possible to claim the rest from other property owned by the mortgagor. Such a remedy is explicitly provided for in the legislation, although, in this case, the mortgagee will not have any claims satisfaction preferences (privileges) over other creditors of the mortgagor (if any). 

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