It used to be the case that mortgage creditors could rest easy knowing they held a mortgage, and that they would be repaid with the proceeds of the sale of the mortgaged asset, even in the event of an insolvency.

While that assertion remains true in principle, a number of qualifications and limitations should now be taken into account as insolvency regulations evolve. Rapidly changing regulations (twice in the month of September) are turning the relationship between mortgages and insolvency into an increasingly complex area.

For example, the Insolvency Law (Law 22/2003, dated 9 July) provided that, in order to increase the likelihood of saving the insolvent company, any mortgage enforcement would be suspended for a maximum period of 12 months from the moment of declaration of the insolvency by the court, unless the auction date had already been fixed.This was later amended (in a major reform approved in 2011, following two other major reforms in 2009) to the effect that the suspension would take place even if an auction date had already been fixed, in the case of assets considered necessary for the continuation of the company’s business. Only non-core assets (that is, assets which the insolvency court expressly declares are unnecessary for the company’s business activity) may be enforced against without this waiting period.

The suspension regime was also amended by the creation of a pre-insolvency period (commonly known as the “5.bis” period, after the article of the Law which regulates it), during which the debtor can unilaterally declare a three- month period to renegotiate with its creditors with the aim of avoiding insolvency.

If no agreement is reached during those three months, the debtor will be obliged to file for insolvency during the fourth month, or any creditor can apply for the debtor’s insolvency. No enforcement of mortgages (or indeed, as recently amended, enforcements of any other financial claims, if creditors representing 51 per cent of the financial liabilities are participating in the renegotiation) can be initiated during the 5.bis period, and those already initiated will be suspended.There is still a waiting period between the end of the 5.bis period and  the declaration of insolvency by the court, which can last several months, but knowing that the debtor has filed for insolvency tends to be enough for the court in charge of the mortgage enforcement to drag its feet until the insolvency court issues the formal declaration of insolvency.

However, even if the mortgage creditor was forced to wait for a year, or until such earlier time as the insolvency court officially gave up on the chance of an arrangement with the creditors and sent the company into liquidation, at the end of this period it was still possible to enforce the mortgage, auction off the property and secure repayment with the proceeds. In the event that there were no bidders or the bids were too low, applying a rather convoluted set of conditions, the creditor could even be awarded the property at a fraction of the reference value set out in the mortgage for auction purposes (50 per cent, later increased to 60 per cent in the case of the property subject to the mortgage being the usual residence of the debtor) and part of the debt might still remain outstanding. At the height of the financial crisis, and fearing the banks’ capacity to speculate and make a later easy profit out of selling homes repossessed for a pittance, this also was amended to provide that if the property was re-sold within two years and the creditor made a profit, this profit had to be applied to the outstanding debt.

The ability of a debtor to oppose the enforcement of a mortgage was very limited, as the Spanish procedural code allowed the debtor only to object that (i) the mortgage had expired; (ii) there was no longer an obligation to pay; or (iii) that the amount claimed had been calculated incorrectly. After some pretty damning rulings by the European Court of Justice, which considered that consumers were left severely unprotected by this system, it was reluctantly admitted that the debtor might claim that the enforcement itself or the claimed amount was based on abusive provisions in the mortgage imposed on the debtor without negotiation (such as, classically, floor interest rate arrangements). However, there was no opportunity to appeal  in such cases, and this also was frowned upon by the European Court of Justice, so the regulation has recently been amended again to allow appeals. Obviously the enforcement of the mortgage will not be able to proceed until such appeals are resolved, which will slow down enforcement proceedings.

As an additional turn of the screw, the ability to enforce at all has been curtailed by two recent amendments to the Insolvency Law (Royal Decree- Law 4/2014, dated 7 March, as finally redrafted by Law 17/2014 dated 30 September, and Royal Decree 11/2014, dated 5 September). Unfortunately, these amendments are highly complex and require some detailed explanation.

Originally, since mortgage creditors were considered to be privileged creditors, they were not obliged to enter into any sort of arrangement with the other creditors, because their debt was already guaranteed by the mortgage on the property and nothing else was needed.A chink in this armour was first created when it was established that any additional guarantees (such as a new mortgage, or an increase in an existing mortgage) created to secure a previously existing debt were to be considered as suspect and could be invalidated if they had been given or created during the legal clawback period of two years prior to the insolvency.Then, in order to motivate the creditors to negotiate, it was provided that the clawback would not apply to arrangements reached with creditors during the pre- insolvency period, provided that the arrangement provided fresh funds, wiped out some of the debt or established a waiting period, and was underwritten  in a notarial deed by creditors representing at least 60 per cent of the company’s liabilities, following an independently approved viability plan for the debtor. Note that this has just been amended so that the viability plan now needs to be approved by just the auditor. Fresh funds deriving from these arrangements then actually became privileged in the event that the insolvency finally came to pass.

The latest 2014 amendments again try to push creditors to renegotiate, this time during the insolvency, by establishing a sort of legal “drag-along” for financial creditors (whether privileged or not) unwilling to negotiate when a sufficient majority of the remaining financial creditors are willing to reach an agreement.A “sufficient” majority here means 75 per cent for syndicated loans, unless the loan itself provides for a lower majority, and 60,  65, 75 or 80 per cent for other financial creditor arrangements, depending on the content of the arrangement and the value of the mortgage.

The “value of the mortgage” is a wholly novel concept introduced by Royal Decree- Law 4/2014, and it is equivalent to 90 per cent of the reasonable value of the property (that is, its market value as determined by an official valuation no more than six months old) minus the value of any prior charges (such as preferential ranking mortgages) that will remain in force after the enforcement of the mortgage, capped by the actual amount of the outstanding debt secured by the mortgage.

As from 7 September 2014, when Royal Decree 11/2014 came into force, only that part of the debt secured by the mortgage which does not exceed the “value of the mortgage” is to be considered privileged, the remainder being classified as ordinary debt.

This “value of the mortgage” is used by the new legal provisions in such a way that any part of the debt secured by the mortgage that actually exceeds the value of the mortgage can be “dragged along” and made to submit to the arrangement approved by financial creditors representing 60 per cent of the insolvent company’s financial liabilities, if it involves a waiting period not exceeding five years or converting the loans into profit sharing loans for the same duration.The majority must be 75 per cent if the arrangement entails (i) waiting periods of between five and ten years; (ii) waiving part of the debt; (iii) conversion of the debt into equity in the insolvent company (unwilling creditors may opt instead for a waiver of the amount of the debt they should have converted); (iv) conversion of the debt into profit sharing loans with terms of between five and ten years, subordinated loan convertible bonds or any other sort of financial instrument with terms differing from the original debt; or (v) debt-for-asset swaps.

On the other hand, the part of the debt secured by the mortgage that is actually within the value of the mortgage can also be dragged along, in the same terms, but using a majority of 65 per cent instead of 60 per cent, and 80 per cent instead of 75 per cent.

All these majorities are also counted in a novel way.Traditionally, creditors were divided into privileged (that is, secured), ordinary or subordinated. Privileged creditors, in turn, could have a special privilege, if secured by a specific asset (mortgage or pledge holders), or a general privilege (if secured generally by the rest of the debtor’s assets, mainly the tax authorities and employees). While these categories still exist, a further classification has been established in terms of classes of privileged creditors: “employment creditors” (employees),“public law creditors” (public agencies), “financial creditors” (whether credit entities or not) and “other creditors”.The drag- along in the arrangements only happens when the arrangement is approved by the majorities mentioned above of those creditors in the same classAnd particularly, as regards especially privileged creditors such as mortgage creditors, the majority is counted in terms of especially privileged creditors voting within the same class as the unwilling creditor.

While it is still too soon to gauge how market practice will evolve in response to these new changes in the legal framework, it seems clear that financing entities will need to tread with care, both 1) in judging creditworthiness of borrowers, careful drafting of loans and mortgages, and the ability to trust fellow financiers when splitting a ticket or granting finance to already indebted companies, and 2) definitely when facing a possible renegotiation of debt in the face of impending insolvency.