Extract taken from 'The Lending and Secured Finance Review' – edition 5
Credit support and subordination
German law provides for several types of security interests. The main distinction is between accessory and non-accessory security interests.
Accessory security interests, such as pledges over receivables or shares, and mortgages over real estate, can only exist in conjunction with the secured claim or claims. In other words, they automatically lapse as soon as the secured claim is finally discharged or even exchanged. In addition, accessory security interests can be created for the benefit of the creditor of the secured claim only. Therefore, an accessory security interest cannot be transferred without simultaneously assigning the secured claim. This creates certain legal challenges for trading secured loans (see Section VI).
By contrast, the existence and validity of non-accessory security interests is legally independent from the existence of any secured claims. The link between the security interest and the secured claims is created by means of a security purpose agreement. For non-accessory security interests, agency structures do not pose any particular problems, and the secured claims can easily be exchanged. Generally, non-accessory security interests, such as assignments of receivables, security transfers of title to movables or land charges, are preferred over accessory security interests.
If more than one security interest has been created with respect to the same collateral, the earlier security interest would be senior in rank to the later security interest as a matter of law as far as pledges and land charges are concerned, or the later encumbrance would not be valid if the grantor no longer holds the title to the collateral, such as in the case of a prior assignment or transfer for security purposes. The order of priorities can be amended by contractual arrangement, which is commonly done through intercreditor agreements in the case of transactions involving various groups of secured creditors.
Apart from certain procedural constraints, enforcement of security is subject to a number of limitations. In the case of upstream or cross-stream security, enforcement against the assets of the security-granting subsidiary is usually limited to protect the security grantor's registered capital (based on a balance-sheet test) and sometimes also the liquidity of the security grantor, thereby shielding its management from potential personal liability, unless the loan proceeds have been made available to the security grantor ('limitation language', which will usually be addressed in German law legal opinions (see Section V)). For the statutory rules concerning the subordination of shareholder loans, see Section VII.
For certain security interests, the insolvency administrator may be entitled to control the enforcement process and retain a certain percentage of the enforcement proceeds for the benefit of the insolvency estate (haircut). German insolvency law also provides for a number of contestation rights that insolvency administrators frequently use to challenge transactions (including loan repayments or the creation of security) during certain suspect periods that can extend to up to 10 years prior to the filing for the opening of insolvency proceedings. German courts have given a very broad interpretation to a number of these contestation rights, and contestation rights have become a significant area of concern to lenders in any dealings with borrowers who experience – or might in the foreseeable future experience – economic difficulties.