Fraudulent debtors are trying to use a disputable interpretation of Article 37, para 4 of the Special Pledges Act on the outcome of enforcement over a special pledge against the rights of secured mortgage creditors.

The Bulgarian legislator is notorious for leaving gaps in enacted legislation. Often such legal gaps combined with inexperience, or even worse – corruption of judges, lead to questionable judgments being handed down. Several of these judgments have put mortgage creditors at risk of losing their collateral in the past year.

Special pledge vs. mortgage

In Bulgaria, a mortgage has long been regarded as one of the most reliable forms of collateral. Thus, it is the preferred instrument of most creditors, including the most important – in terms of creditor rankings – the banks. Although a mortgage has its own disadvantages compared with other types of securities, eg a special pledge (особен залог) or financial collateral (eg the costs are higher, the procedures for establishment and enforcement usually take longer, etc), Bulgarian creditors still prefer to use it.

The financial crisis in Bulgaria led to many bankruptcy proceedings. Once such a proceeding is opened with respect to a debtor, all other enforcement proceedings are sus-pended. Thus, a mortgage creditor should wait for the completion of any bankruptcy proceeding in order to receive its share of the sold real property. This can take several years, however, compared with enforcement on a mortgage, which can be completed in months.

Nevertheless, enforcement of a special pledge is not suspended by the start of insolvency proceedings, and a creditor can sell the pledged property without going to court. Yet Bulgarian banks are still hesitant to replace a mortgage with a special pledge. Their biggest concern is that since the creditor is selling the pledged property on its own, the debtor could later claim that the sale went through at a very low price and claim damages.

The “hidden” benefit of the special pledge

Although the banks are still hesitant to opt for special pledges, in the past couple of years other creditors, mostly from off-shore zones with unknown owners, are pleased to use this security instrument. Such creditors have even registered special pledges on real properties which were already encumbered with mortgages when their owners were on the verge of bankruptcy. Soon thereafter, these creditors will enforce on the collateral and sell the real property to a new owner, irrespective of any ongoing bankruptcy proceedings or mortgage enforcement.

To an uninformed reader, it could sound strange that anyone would choose to use already encumbered property as collateral, or would buy it against a price close to its market value. However, this scheme has come into use due to a certain legal gap which fraudulent debtors try to exploit.

The special pledge was introduced in Bulgaria in 1997 and since it was a totally new security instrument, it still provides a challenge for both the legislator and judges working with it. Thus, there is no explicit legal provision regulating the conflict between a registered mortgage and a special pledge on one and the same property. Although normal logic dictates that the first registered should take priority, there is a provision in the Special Pledge Act which gives ground to some judges to consider that an enforcement of a special pledge over real property should lead to deregistration of any prior encumbrances on it, including any mortgage. Thus, the mortgage creditor could end up without any collateral.

This disputable interpretation has already led to several court disputes with different out-comes. Therefore, the Supreme Court is currently preparing an interpretive judgment which should fill this gap.

There is no explicit legal provision regulating the conflict between a registered mortgage and a special pledge on one and the same property.