Shiri Shaham Shai Margalit September 27 2022 Israeli Supreme Court rules on re-characterisation of pledges as floating charges Arnon, Tadmor-Levy | Banking & Financial Services - Israel Shiri Shaham, Shai Margalit Banking & Financial Services IntroductionBackgroundFactsDecisionCommentIntroductionCompanies often create security interests for the benefit of creditors over fluctuating pools of assets. This is the case where a bank account or a securities account is being pledged and equally where receivables or other future rights are pledged. While in the case of a debenture creating the pledge the parties usually characterise such pledges as fixed pledges or fixed charges (pledges and charges are synonyms in this context), the question had always been left unanswered as to whether such pledges are at risk of, at some point, a court holding their true nature to be that of a floating charge.While there have been district court rulings discussing this question in various scenarios, as well as certain obiter comments by Supreme Court judges, this is the first time that the Supreme Court has directly addressed this question in the context of pledges of bank accounts and receivables.BackgroundIf the pledgor enters into insolvency proceedings, the question of whether a pledge is fixed or floating is important for two main reasons:Floating charges are inferior in the creditors' priority order upon insolvency. They rank after fixed charges and certain statutory preferred debts (such as certain taxes and employees' wages), while fixed charges rank higher in priority to such preferred debts.Floating charges secure only 75% of the debt of the insolvent company to the secure creditor, while the remaining 25% is considered an unsecured debt.There are additional implications to this characterisation, as can be seen from the facts of the court case.FactsThe key facts of the case in Civil Appeal 2966/17 Accord v the State of Israel, dated 29 August 2022, were as follows:A company took credit from a creditor named Accord and pledged in its favour two bank accounts and its receivables (ie, its rights to receive payments from certain clients).These pledges were characterised in the debentures creating them as fixed and were registered as such.The company was thereafter indicted in certain economic and money laundering criminal offences, and in such proceedings the state of Israel is entitled to forfeit the assets of the indicted company.The state requested to forfeit funds that were then in the pledged bank accounts of the company and that derived from the pledged receivables.Accord, the creditor, objected to such forfeiture and argued that it was entitled to receive those funds based on the pledges granted in its favour.DecisionThe Supreme Court first ruled, based on former rulings, that in this competition between the creditor and the state, the creditor will prevail if the assets are pledged under a fixed pledge, while the state will prevail if the assets are subject to a floating charge. Hence, the Court needed to determine the nature of these pledges and whether, notwithstanding their characterisation by the parties as fixed charges, they should be re-characterised as floating charges.Re-characterisation – relevant factorsThe Court first clarified that the characterisation of a pledge as fixed or floating will mainly derive from the substance of the pledge and its terms, while the name given to it by the parties is not a strong factor in this analysis. The Court mentioned the following three main factors that should be examined, in the aggregate:the specificity of the pledged assets – where the debenture creating the pledge determines accurately and specifically the assets subject to the pledge, this is an indication of a fixed pledge, while a more open or vague definition is an indication of a floating charge;the nature of the pledged assets – the Court indicated that the law recognises the possibility to create a fixed pledge over future assets. Nevertheless, where the pledge is imposed over a fluctuating pool of assets that may include assets not yet owned by the pledgor at the time of the creation of the pledge, this may support the classification as a floating charge, while a fixed pledge would more typically be imposed on fixed assets already owned by the pledgor; andthe level of control of the secured creditors over the pledged assets – the main characteristic of a floating charge is the freedom granted to the pledgor in respect of the pledged assets in connection with their use and transfer. Under the terms of a fixed pledge, the pledgor is usually very restricted with respect to using or transacting in the pledged asset without the prior consent of the secured creditor. The Court noted in this respect that not all restrictions are necessarily indicators of a fixed charge, since it is common that certain restrictions apply also under the terms of floating charges (eg, the terms of most floating charges prohibit the pledging of the assets in favour of another creditor).Upon analysing the opinions of the judges, the third factor seems to be the most important of the three.Court's re-characterisation of pledge on bank accountsThe debenture creating the pledge in this case classified the pledge on the bank accounts as fixed. Under its terms the creditor had viewing rights in the accounts and the pledgor undertook not to make any disposition of the pledged assets. Nevertheless, the pledgor was entitled to withdraw funds out of the accounts freely and to use them for any purpose not prohibited under the debenture.The main grounds for the Court's re-characterisation of these pledged assets as floating charges were that:changes in the composition of the assets in the accounts were permitted. Therefore, the creditor could have no certainty as to what the scope and value of the assets would be if and when the pledge were realised. Hence, the creditor took the risk that, upon realisation, the bank accounts would be empty and there would be no funds; andthe pledgor had full freedom to act in the account as it wished until an event of default occurred and the secured creditor had almost no control of the assets.Court's re-characterisation of pledge on receivables The debenture creating the pledge in this case classified the pledge on the receivables as fixed. The pledged assets were defined as all the rights, funds and payments to which the pledgor will be entitled from time to time from certain clients. While the names of the clients were specified in the debenture, there were no details as to the specific agreements with them nor of specific receivables. The pledgor undertook not to make any disposition of the pledged assets and not to waive any rights in respect of the clients without the consent of the secured creditor.The Court ruling regarding the receivables was adopted as a majority decision against the dissenting opinion of a minority judge, who agreed with the classification of the pledge as fixed.The majority judges resolved to re-characterise the pledge on the receivables as a floating charge, based on the following main grounds:The pledged assets were not sufficiently specific, but rather it was a pledge on a general pool of changing assets.The secured creditor did not have any effective control on the funds paid to the pledgor by the clients under the receivables. The Court gave weight to the fact that under the terms of the debenture the creditor could have required the deposit to escrow the funds received, but chose not to do so, thereby allowing the pledgor to freely use the funds without exercising any control over them.The Court explained that if the pledgor was required to direct all the funds received under the receivables to a special account controlled by the creditor, this would constitute control by the creditor over the receivables and would likely lead to a characterisation of the pledge as fixed.CommentThis case will likely have a big effect on the determination and drafting of terms of pledges and will impact and change the market practice on these matters. Specifically in connection with pledges of receivables, creditors that, compatible with the current market practice, continue to allow the pledgors to use pledged receivables freely until the occurrence of an event of default with no effective control of the creditor over the flow of funds will now be exposed to an increased risk that this pledge will be re-characterised as a floating charge. Equally, with respect to pledged bank accounts, creditors will have to find effective measures to control the flow of funds out of these accounts. All these control measures will naturally have to be balanced with the needs of the pledgors for business flexibility, so as to enable them to run their business.For further information on this topic please contact Shiri Shaham or Shai Margalit at Yigal Arnon & Co by telephone (+972 3 608 7777) or by email ([email protected] or [email protected]). The Yigal Arnon & Co website can be accessed at www.arnon.co.il.