Israeli Supreme Court rules on reclassification of pledges as floating charges – Commentary

Introduction
Background
Facts
Decision
Comment

Introduction

Companies often create security for the benefit of creditors over fluctuating pools of assets. This is the case in the event of a pledge of a bank account or a securities account and also in the event of a pledge of receivables or other future rights. Whereas in the case of an obligation creating the pledge, the parties generally qualify these pledges as fixed pledges or fixed charges (pledges and charges are synonymous in this context), the question has always been left unanswered whether such promises are at risk ofat one point, a court finding that their true nature is that of a floating charge.

While there have been district court rulings addressing this issue in various scenarios, as well as some obiter comments from Supreme Court justices, this is the first time the Supreme Court has directly addressed this issue in the context pledges of bank accounts and receivables.

Background

If the pledgor initiates insolvency proceedings, the question of whether a pledge is fixed or floating is important for two main reasons:

• Floating charges are lower in the order of priority of creditors in the event of insolvency. They rank after fixed charges and certain statutory privileged debts (such as certain taxes and employee salaries), while fixed charges take priority over these privileged debts.
• Floating charges only secure 75% of the insolvent company’s debt to the secured creditor, while the remaining 25% is considered unsecured debt.

There are additional implications to this characterization, as the facts of the court case show.

Facts

The main facts of the case in Civil Appeal 2966/17 Agreement against the State of Israelas of August 29, 2022, were as follows:

• A company took out credit from a creditor named Accord and pledged two bank accounts and its claims (i.e. its rights to receive payments from certain customers) in its favor.
• These pledges were characterized in the obligations creating them as fixed and were recorded as such.
• The company was later charged with certain economic and money laundering criminal offences, and in such proceedings the State of Israel is entitled to confiscate the assets of the indicted company.
• The State requested the confiscation of the funds which were then in the pledged bank accounts of the company and which came from the pledged receivables.
• Accord, the creditor, opposed this confiscation and asserted that it was entitled to receive these funds on the basis of the pledges granted in its favour.

Decision

The Supreme Court first ruled, based on previous judgments, that in this competition between the creditor and the State, the creditor will prevail if the goods are pledged in fixed pledge, while the State will prevail if the property is encumbered with a floating charge. Consequently, the Court had to determine the nature of these pledges and whether, notwithstanding their characterization by the parties as fixed charges, they should be reclassified as floating charges.

Re-characterization – relevant factors
The Court first clarified that the qualification of a pledge as fixed or floating will derive mainly from the substance of the pledge and its terms, while the name given to it by the parties is not an important factor in this to analyse. The Court mentioned the following three main factors that should be considered, overall:

• the specificity of the pledged assets – where the debenture creating the pledge accurately and precisely determines the assets subject to the pledge, this is an index of a fixed pledge, whereas a more open or vague definition is an index of a floating charge;
• the nature of the pledged assets – the Court indicated that the law recognizes the possibility of creating a firm pledge on future assets. However, where the pledge is taxed on a fluctuating pool of assets which may include assets which were not yet held by the pledgor at the time the pledge was created, this may justify classification as a floating charge, then that a fixed pledge would more generally be taxed on fixed assets already held by the pledger; and
• the level of control of pledgees over the pledged assets – the main characteristic of a floating charge is the freedom granted to the pledgor with respect to the pledged assets in the context of their use and transfer. Under a fixed pledge, the pledger is generally very limited in using or dealing with the pledged property without the prior consent of the secured creditor. The Court noted in this regard that not all restrictions are necessarily indicators of a fixed charge, since it is common for certain restrictions to also apply in the context of floating charges (for example, the conditions of most floating charges prohibit the pledging of assets in favor of another creditor).

After analyzing the judges’ opinions, the third factor seems to be the most important of the three.

Requalification by the Court of the pledge on the bank accounts
The debenture creating the pledge in this case classified the pledge on the bank accounts as fixed. Under its terms, the creditor had a right to inspect the accounts and the pledgor undertook not to proceed with any alienation of the pledged property. Nevertheless, the pledgor had the right to freely withdraw funds from the accounts and use them for any purpose not prohibited by the debenture.

The main reasons for the reclassification by the Court of these assets pledged as floating charges were as follows:

• changes in the composition of assets in the accounts were permitted. Therefore, the creditor could have no certainty as to the extent and value of the assets if and when the pledge was realised. Thus, the creditor has taken the risk that upon completion, the bank accounts will be empty and that there will be no more funds; and
• the pledgor had complete freedom to act on the account as it saw fit until an event of default occurred and the secured creditor had virtually no control over the assets.

Reclassification by the Court of the pledge on receivables
The debenture creating the pledge in this case classified the pledge over the receivables as firm. Pledged assets have been defined as all rights, funds and payments to which the pledgor will be entitled from time to time from certain customers. Although the names of the clients were specified in the debenture, there were no details as to the specific agreements with them or the specific claims. The pledgor has undertaken not to proceed with any alienation of the pledged goods and not to waive any rights with regard to the clients without the agreement of the pledged creditor.

The judgment of the Court regarding the claims was adopted by a majority against the dissenting opinion of a minority judge, who approved the qualification of the pledge as a pledge.

The majority judges decided to reclassify the pledge on floating charge claims, on the basis of the following main reasons:

• The pledged assets were not specific enough, but rather a pledge on a general pool of changing assets.
• The secured creditor had no effective control over the funds paid to the pledge by the customers in respect of the claims. The Court gave weight to the fact that under the terms of the debenture, the obligee could have demanded the deposit to block the funds received, but chose not to do so, thus allowing the pledgor to freely use funds without exercising any control over them.

The Court explained that if the pledgor were required to pay all funds received in respect of the claims into a special account controlled by the creditor, this would constitute control by the creditor over the claims and would probably lead to the pledge being qualified as a pledge. .

Comment

This case is likely to have a significant effect on the determination and drafting of the terms of pledges and will impact and change market practice on these issues. With specific regard to pledges of receivables, creditors who, in accordance with current market practice, continue to allow pledgers to freely use the pledged receivables until the occurrence of an event of default without effective control of the creditor on the flow of funds, will now be exposed to an increased risk that this pledge will be reclassified as a floating charge. Similarly, with respect to pledged bank accounts, creditors will need to find effective measures to control the flow of funds out of these accounts. All of these control measures will naturally have to be weighed against the pledgers’ needs for commercial flexibility, in order to enable them to manage their business.

For more information on this, please contact Shiri Shaham or Shai Margalit at Yigal Arnon & Co by phone (+972 3 608 7777) or email ([email protected] Where [email protected]). Yigal Arnon & Co’s website can be accessed at www.arnon.co.il.