Collateral in Russia: Recent Developments

Collateral in the form of real or personal property known in Russia as zalog, (hereafter “Collateral”) is considered as one of the most effective instruments ensuring the proper discharge of obligations. A person puts down collateral by conveying an interest in property to a creditor, endowing him with a right to cover the debt from the value of the property in case of debtor’s default primarily before unsecured creditors.

The history of collateral traces its roots back to remote past. This instrument was known in Ancient Rome where two forms of collateral were distinguished – pignus and hypoteca. Since that time collateral has not lost its meaning, though there may be some differences in its legal regulation. In common law it is collateral or mortgage, in German law - pfand and grundpfand, in French – gage and hypothèque, in Russian law – zalog and ipoteka.

Collateral in Russia was widely applied before the revolution of 1917. In Soviet times the sphere of its application was rather small and the respective regulation was very poor. For example, there was no such institute as hypothec at all (collateral in the form of real property). The institute of collateral was revived in 1992, with the enactment of the Law on Collateral. In 1995 the respective provisions were included in the Civil Code of the Russian Federation and a special Law on Hypothec was enacted in 1998.

Modern Russian model of collateral:

Under Russian law the main peculiarity of collateral is that a creditor under no circumstances receives property rights to the object put down as a collateral. A creditor only receives the right to cover the debt owed to him from the value of that property in case of debtor’s default by application of the special foreclosure procedure. As a general rule, judicial procedure is required for foreclosure on the property pledged as collateral. However, in some cases extrajudicial procedure is also allowed.

Commonly the property pledged as collateral is left in the possession and usage of debtor. However, such practice is not admitted in some countries where the pledged property is always conveyed to a creditor (possessory collateral).

Often it is not a debtor who puts down the property as collateral. Instead it may be another person or legal entity (e.g. company, affiliated with a debtor, pledges the property to secure debtor’s obligation). In such case a third participant – pledger is also included in structure presented above.

The Position of the Supreme Commercial Court

Without doubts the enactment of new legislation is a significant step forward for the rapidly developing Russian credit market. At the same time controversial judicial practice of enforcement of the new rules demonstrated that courts follow conservative views towards the collateral whereas participants of the civil law relations stay puzzled in a host of innovations.

The Supreme Commercial (Arbitrazh) Court of the Russian Federation (SAC), which instructions are binding for the inferior courts, several times gave its comments on the collateral legislation in order to set the rules for the participants of the civil law relations. As an example in 1998 SAC clarified that if the contract does not properly individualize the object of collateral, the contract is deemed undone. In 2002 – that a contract for collateral in the form of nondocumentary securities is not subject to state registration.

As the credit market kept rising, SAC in its decision again addressed the controversies raised by the practice in connection with collateral application.

“Preserving the Collateral” Message

In its instructions SAC adheres to the idea of “preserving the collateral”, overcoming the conservative attitude of courts, often construing the gaps in legislation in favor of debtor. As the creditors’ position was left unenviable SAC decided to intervene. Below we will shed some light on the key points of the instructions given by SAC regarding the collateral (in the form of real property and of personal property as a whole), which demonstrates the new approach towards the problem.

Changes in Secured Obligation

In practice it is often the case when the interest rate on the given loan or its term is changed. Earlier in such case the courts considered the collateral ceased. As the result, the creditor entered into the loan agreement on fluctuating terms was left absolutely unsecured.

Nowadays, according to the instructions of SAC, the collateral does not cease, it continues serving as security for the loan, though, on its previous terms.

Cancellation of Secured Obligation

A contract may be rescinded by a creditor in view of various circumstances. For example, when the creditor is sure in the debtor’s inability of proper performance and the delay in such performance will cause additional damages. The contract is rescinded. What happens to collateral remained?

It may seem obvious that collateral continues serving as a security for the primary obligation even after the contract is rescinded. But courts have chosen a different approach: they declared the collateral ceased along with the contract. SAC explained that a creditor keeps the right to use the foreclosure procedure, demonstrating again its adherence to the idea of “preserving the collateral”.

Initiation of foreclosure procedure

Often the property is pledged not by the debtor, but by another person or entity to secure the debtor’s obligation. However the law is silent about the way in which a creditor must act if he wants to cover the debt by foreclosure on the pledged property belonging to the third party.

In practice creditors faced many issues: whether it is possible to initiate foreclosure procedure right after sending a notification to its owner? Or it is necessary, at first, to send a formalized notice to the debtor? Or maybe it is necessary to do both simultaneously?

Courts almost never favored creditors, making them, first, recourse to debtor, wait his answer and only then allowed to recourse directly to mortgagor. After considering all pros and cons, SAC decided to give freedom of actions to creditors: now they are allowed to send notification to a pledger immediately without prior obligatory recourse to a debtor.

Some Questions Were Left Open

At the same time, SAC left some questions open. The biggest issue remained for creditors is the possibility of extrajudicial foreclosure on the pledged property still remained unresolved.

Russian legislation allows extrajudicial foreclosure on the property put down as collateral. It significantly simplifies the life of creditor, saves his time and money. Unfortunately, in practice this procedure does not work because the property pledged almost always remains in debtor’s possession, being the essential convenience of collateral. In order to initiate foreclosure a creditor must seize the pledged property from debtor’s possession. If a debtor refuses to give away the property, a creditor recourses to notary for enforcement endorsement. But under Russian legislation, if a debtor raises an objection, notary has no right to make such endorsement. SAC established that creditor’s sole option in such case is to recourse to court.

As a whole, new instructions can be evaluated positively. Today SAC gives the participants of the civil law relations a signal: collateral mechanism may be reliable enough if applied competently. Though some problems still remained unsolved, we can hope that the practice will soon become more rational, and will allow the participants of the civil law relations to predict and minimize their risks when making their deals.

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