Supreme court confirms banks priority over rental income on mortgaged property in insolvency proceedings
Polish Supreme Court resolution, 14 May 2014, case No III CZP 18/14
The Supreme Court has ruled that post-insolvency rental income on a mortgaged property is covered by the mortgage, and thus the mortgagee has priority over this income. A&O Warsaw advised a European bank, which initiated the litigation. The ruling has been welcomed by the financial sector because it clarifies how possible recovery rates should be calculated in real estate finance projects.
A key feature of a mortgage loan is that the lender's interest is secured over a specific property owned by the mortgagor. The lender has general priority over unsecured creditors in the recovery of proceeds from the forced sale of the mortgaged property. This mechanism reduces a lender's credit risk, thus enabling it to offer a borrower more favourable credit terms in comparison to an unsecured loan. A legal system's ability to support the rights of a mortgagee is critical in terms of a lender's ability and desire to offer commercial secured credit on terms that are more favourable than unsecured credit.
An issue arose in this case concerning the treatment of rent received, post-insolvency, relating to a mortgaged property. Up until now it has been assumed by lenders, albeit not confirmed by the courts, that a mortgagee has statutory priority over post-insolvency rent proceeds.
The administrator-driven liquidation takes time as it requires a court expert's appraisal to be arranged, and the rental income, collected in the meantime, could be significant. Under the statutory distribution waterfall, the mortgagor should receive at least 90% of the purchase price for the encumbered property obtained in an insolvency auction. However, the fire-sale price of the mortgaged property is often lower than the secured claim of the mortgagee. The rent proceeds could therefore compensate the mortgagee for this deficiency in the property value.
The view of some officeholders and unsecured creditors is that, in contrast to bailiff-driven foreclosure, a mortgage does not extend to rental income following the owner's bankruptcy declaration,1 and that such rental proceeds should be treated as an unsecured asset, over which the mortgagee has no priority. Thus, such rent should increase the amount of cash in the general pool of the bankruptcy estate, which can be used to satisfy creditors' claims in accordance with the general statutory order of priority. In practice, this cash is often divided between the bank (the mortgagee), the shareholders (as creditors under inter-company loans), and other (commercial) creditors on a pari passu and pro rata basis.2
Supreme Court: mortgage covers post-insolvency rent
The Polish Supreme Court ruled that, in a bankruptcy liquidation, a mortgage covers the entire post-insolvency rent from the mortgaged property. This ruling will help facilitate further development of real estate finance in Poland. The alternative ruling could have had a negative impact on a bank's (the mortgagee) expected recovery rate in the event of a mortgagor's bankruptcy. In such a case, some banks could become reluctant to engage in Polish real estate finance projects or significantly increase their margins to compensate for the increased credit risk.
Post-insolvency service charges
Following the Supreme Court ruling there are still some areas of uncertainty particularly regarding the treatment of service charges, including management fees and utility charges (charged at cost or fixed in the lease agreement). It is still unclear:
- whether post-insolvency service charges are a part of the rent, which is covered by the mortgage in insolvency, meaning in general that the mortgagee would receive up to 90% of the service charge irrespective of the encumbered property's operations costs incurred by the insolvency administrator; and
- how to treat interest accrued on monies kept in the insolvency administrator's account (including interest on post-insolvency rent and sale proceedings from the mortgaged property)
1. Polish insolvency law provides that if the property owner has "disposed" of rent due for occupying the property in the period following the third month from the owner's bankruptcy, then the tenant shall not be released from the obligation to pay rent directly to the insolvency administrator, ie to the bankruptcy estate. This was interpreted to mean that the mortgage does not extend to the rental income starting from the fourth month of the bankruptcy.
2. Concerning the agreements which aim to prioritise payments from a Polish bankrupt debtor to different classes of pari passu creditors, please refer to the following article: P Bartosiewicz, M Neumann, Enforceability of intercreditor agreements in Poland, European Finance Litigation Review September/October 2013, pages 17-18.