Legal drafting of a standstill agreement with regard to enforcement of a hereditary building right

A. The issue

When a hereditary building right is created on a property, the payment of a ground rent is often agreed between the holder of the hereditary building right and the property owner as consideration for the right to build and for beneficial use by the holder of the right.1 This ground rent is generally secured by registering a land charge for the ground rent in Section II of the hereditary building right land register; section 9(1) of the Hereditary Building Rights Act and sections 1105 et seq. of the German Civil Code apply in this respect. Furthermore, the property owner will have a right of pre-emption (and a priority notice to secure the right to reassessment of the ground rent in the case of older hereditary building rights) registered in the hereditary building rights land register.2 As such, the holder of the hereditary building right invariably acquires the hereditary building right together with the rights registered in Section II. If the holder of the hereditary building right wishes to take out a mortgage on his hereditary building right (or if he is obliged to do this in order to finance the purchase of the hereditary building right), then in accordance with the principle of priority this mortgage is in all cases registered in the hereditary right land register with a lower priority than the rights of the property owner stated above.

However, having a lower priority is often not acceptable to the financing bank, as there is a risk that in the event of a compulsory auction of the hereditary building right the ground rent with the higher priority will be capitalised and as such will fall within the minimum bid in accordance with sections 44(1), 52(1) of the Compulsory Auctions Act, with the bank ultimately left empty-handed.3 A property owner will also rarely be willing to abandon his rights in Section II in favour of a mortgage registered in Section III. In that case, if a mortgagee with higher priority were to pursue a writ of execution against the hereditary building right the ground rent would not fall within the minimum bid but would lapse through acceptance of the bid under section 91 of the Compulsory Auctions Act.4 This would not only result in the property owner being left empty-handed in the compulsory auction, it would also mean that the highest bidder acquires the hereditary building right free from encumbrances, i.e. without a registered land charge for the ground rent.5

The legislature endeavoured to solve this conflict of priorities through the Real Property Adjustment Act of 1 October 1994 by introducing a ground rent for hereditary building rights which shall persist even if compulsory execution is initiated due to a higher ranking right (see point C. below); in the case of all hereditary building rights created up to 30 September 1994, this situation – which was unsatisfactory for all parties – was to be avoided through an agreement on a divergent determination of the minimum bid and the terms and conditions of auction (section 59, Compulsory Auctions Act). This is generally known as the “standstill agreement”, and in some cases “non-capitalisation agreement” or “agreement to accept the existing encumbrances”. Since hereditary building rights are generally created for 99 years, the precise content of this standstill agreement is the crucial factor for the majority of hereditary building rights that are currently enforced. This is discussed in more detail below from the point of view of the mortgagee who is recovering payment and whose mortgage has been registered with lower priority than the rights of the property owner.

B. Solving the conflict of priorities under the “old” law

The centrepiece of a standstill agreement is typically the property owner’s concession that the (higher-priority) ground rent on the hereditary right will not be capitalised for a replacement amount but will instead continue in existence under section 59 and / or section 91 of the Compulsory Auctions Act.6 In an ideal situation, this reconciles the interests of all those concerned: the proceeds of the “lower-priority” mortgagee are not reduced by a replacement amount; the “higher-priority” property owner knows that his claim for payment of the ground rent continues to be secured on the property against the purchaser of the hereditary building right by the continued existence of the ground rent registered as a land charge7; and a hereditary building right of this kind finally becomes “eligible as collateral”, thus also providing a benefit to the holder of the hereditary building right.

In order to achieve this result the following agreement in particular should be incorporated in a standstill agreement as a divergent condition of auction according to section 59(1), sentence 1 of the Compulsory Auctions Act with regard to the registered ground rent:8

  1. The property owner warrants to the mortgagee that, in the event of a compulsory auction of the hereditary building right, he will retain the registered ground rent in relation to the instalments which become due in the future; and
  2. This retention is for the purpose of avoiding capitalisation of the ground rent and of its therefore being taken into account for the minimum bid.9

A declaration of this kind or a similar declaration is sometimes already contained in the hereditary building right agreement, particularly in cases where clerical institutions own the property. Providing an additional standstill agreement, including where this is required for clarification purposes, can often not be enforced subsequently (e.g. where a purchase of an existing hereditary building right is financed via a loan). However, caution is required here from the bank’s point of view: the wording frequently encountered in hereditary building agreements, that in the event of a compulsory auction of the hereditary building right, the property owner will retain the rights to be registered in Section II of the hereditary building right land register in favour of the mortgagee registered in Section III of the hereditary building right land register at the latter’s request, is sometimes not deemed sufficient by compulsory auction courts to bring about the divergent determination of the minimum bid desired by the parties involved.

With regard to the property owner’s declaration above it was explained that there could only be an “either / or” situation: either the right (the registered ground rent) is retained and is taken into account in the minimum bid (reducing the value), or it remains outside of the minimum bid and lapses. According to this interpretation, the wording above to the effect that the registered ground rent for the hereditary building right should be retained in favour of the mortgagee does not mean that the capitalised (future) ground rent cannot be taken into account in determining the minimum bid, reducing the amount accordingly. Furthermore this was held not to be a case of section 52(2), sentence 2 a) of the Compulsory Auctions Act, which makes explicit reference to the possibility of a ground rent for the hereditary building right that “cannot be auctioned” under section 9(3) of the Hereditary Building Rights Act – although this relates to the “new” law.

There is no objection to this “formal” approach, as far as it goes. However, in the case referred to, the higher-priority registered ground rent for the hereditary building right would already be retained in the compulsory auction under the principle of acquisition and – in the event that no divergent auction conditions had been agreed – be capitalised and taken into account accordingly in the minimum bid, reducing the value.10 This now results in a situation which none of the parties involved in the compulsory auction had wanted: the purchaser acquires a hereditary building right for a fraction of the actual value and the claims of the bank remain largely unsatisfied since the minimum bid is far below the market value of the hereditary building right.

C. Further risks from the mortgagee’s viewpoint

Even if the standstill agreement has the desired result that the higher-priority registered ground rent for the hereditary building right is not capitalised to the detriment of a lower-priority mortgagee, this still does not mean that the mortgagee receives full settlement from the proceeds of the auction.11

The collateral value of a hereditary building right is often based on an expert valuation submitted by the holder of the hereditary building right which has already taken into account the fact that the matter involves a hereditary building right (and therefore concerns the building only) and not “full ownership” of property. The valuation commissioned by the auction court in the course of a compulsory auction in order to determine the current market value will also take this fact into account, with the value being reduced accordingly. This can involve a comparative factor of 0.85 of the value of the property being applied to allow for the hereditary building right.

However, the minimum bid is often still set below this value, which has already been reduced, as the highest bidder does not ultimately acquire the hereditary building right without encumbrances, but rather encumbered with the registered ground rent for the hereditary building right which imposes a long-term payment obligation on him. There is thus actually a double deduction. The amount of a hereditary building right’s “eligibility for collateral” is therefore generally to be assessed in practice at a maximum of 60 – 80% of the market value of the hereditary building right, depending on the residual term of the hereditary building right. However, this is not always taken into proper consideration in practice when granting a loan.

D. The “new” law since 1 October 1994

For hereditary building rights created after the Real Property Adjustment Act of 1 October 1994 came into force (BGBL. I P. 2457 / 2489), there is the option of agreeing a ground rent (for the hereditary building right) which “cannot be auctioned” and which therefore shall persist even if compulsory execution is initiated due to a higher ranking right. In accordance with the new section 9(3), no. 1 of the Hereditary Building Rights Act, an agreement can now be entered into as part of the hereditary building right agreement whereby, in derogation from section 52(1) of the Compulsory Auctions Act, the registered ground rent for the hereditary building right is retained with its principal claim should the holder of an overriding or equivalent right secured by property pursue compulsory auction of the hereditary building right. Under section 52(2) of the Compulsory Auctions Act the registered ground rent for the hereditary building right is also retained where the ground rent has not been taken into account in determining the minimum bid.12

This means that under the new law, a property owner would now be able to agree – effectively without any risk – that his registered ground rent for the hereditary building right should be subordinated to a mortgage in the event that a non-auctionable ground rent has been agreed for the hereditary building right. This may occur both when the hereditary building right is created in the hereditary building right agreement as well as subsequent to this. In the case of a subsequent agreement, it should be noted that under section 9(3), sentence 2 of the Hereditary Building Rights Act, consent is required from the creditor who has an overriding or equivalent priority to the registered ground rent for the hereditary building right.

Nevertheless, the situation described at the start has not changed fundamentally even after 1 October 1994. On the contrary, the options provided in section 9(3), no. 1 of the Hereditary Building Rights Act are not exercised that frequently even where new hereditary building rights are created. Abandoning the priority of a registered ground rent for a hereditary building right in favour of a mortgage obviously still represents too much of a (psychological) hurdle for the property owner, even when the registered ground rent “cannot be auctioned”.