New Hungarian legislation on security interests: an improvement in the Hungarian secured lending environment

Author: István Gárdos


Law in Transition, Summer/1996

New Hungarian Legislation on Security Interests: An Improvement in the Credibility of Hungarian Companies

A major amendment to the Civil Code concerning charge ("zálogjog") was introduced by the Hungarian legislature on 9 April, 1996 to provide a proper legal framework for the efficient operation of security interests and to encourage secured credit transactions in Hungary. The Act makes use of the latest international developments, such as the Model Law on Secured Transactions prepared on the initiative of the European Bank for Reconstruction and Development.

The new legislation is based on the principle of a unitary security interest system and it provides flexibility to the parties involved. New possibilities arise, such as:

  • a non-possessory charge on movable assets, permitting the creation of a charge and at the same time allowing the chargor to maintain possession of the charged asset;
  • an enterprise charge, permitting the creation of a general charge over all or a part of the debtor's assets without preventing the use and natural circulation of the charged asset;
  • reservation of the rank of a deleted registered charge, permitting the creation of a charge which takes priority over registered charges already in existence;
  • an independent charge, permitting the creation of a charge as a primary obligation of the chargor.

The more liberal approach is also illustrated by the modernisation of the enforcement mechanism. It allows the parties to keep court involvement to a minimum by choosing "private" methods of enforcement.

  • Unitary system

The new legislation is officially described as a unitary system, meaning that the same rules apply to all kinds of collateral. In principle the law allows the parties to establish both a possessory charge(pledge) and a non-possessorycharge (registered charge) on any type of assets. However, on closer examination, we can see that the nature of the asset practically determines the available form and the applicable rules of the security interest. For example:

  • possessory charges over immovables require both possessions and registration;
  • registered charges over movables, immovables and certain ships, aircrafts and patents are registered by different authorities into different registries;
  • enterprise charges require only a general identification of the charged property;
  • charges over transferable rights and claims are regulated by specific rules which reflect the intangible nature of these assets.

Forms of security interests

The new legislation gives freedom to the parties to choose a form of security. In choosing, the parties have to consider many factors, such as the level of "comfort" given to a creditor, restrictions on use of a charged asset by the chargor, and the cost of registration. The different forms of security interests can be characterized by answering the following questions:

  • What kind of property may be the subject of the security?
  • Who is in possession of the collateral?
  • Is registration required? If yes, in which registry?
  • Can the chargor transfer the assets free of the charge?

The table on page 9 provides a comparison of the different forms of charges based on these questions.

Possessory charge

The Act has maintained the traditional possessory pledge ("kézizálogjog") over movableswhich, however, has ceased to be the exclusive form of charges on movables. An important characteristic of this pledge is that the pledge it only exists as long as the collateral is in the possession of the chargee; the pledge is automatically terminated as soon as the pledgor loses possession of the charged asset.

Further more, the Act allows the creation of possessory charge over immovables as well. To create a possessory charge over immovables, the charge has to be registered in the Land Registry. Therefore, in cases of an immovable, there are three requirements for a pledge to be effective: written agreement, possession and registration. As the role of the registration is very much the same as of possession (to make visible to third parties the existence of the charge), an ordinary lender probably will not chose this type of charge over immovables, but will be satisfied with a registered charge.

Registered charge

Before the Act registered charges were allowed only on immovables and certain movables and rights. There had long been a need for a non-possessory charge over movables so that the borrower may offer these assets as security and at the same time pursue its business in the ordinary way. This need was satisfied in case of bank loans by way of a special type of charge for these cases. Even this charge, however, could not be registered, which made it vulnerable as security.

The Act permits to create a non-possessory registered charge ("jelzálogjog")on any kind of property and without respect to the status of the creditor (bank or other). To create an effective non-possessory charge, (i) a written security agreement has to be concluded between the chargor and the chargee (in cases where the collateral consists movables or an individually unspecified pool of assets, this agreement has to be in the form of a notarized document); and (ii) the charge has to be registered in the appropriate registry.
There are several registries. Apart from the Land Registry, which is the most important one, there are separate registries for aircrafts, ships and patents. The registry for non-possessory charge on movables and for enterprise charges (and possibly for charges on rights as well) is being developed and will be administered by the Hungarian National Chamber of Notaries.

There is a significant difference between the proposed Notary Registry and all the other registries. The current registries include every property of a certain type (e.g. every piece of land in the country) and certain data (e.g. regarding the owner) required by the relevant legislation. When a charge is created on a certain property, the charge is registered on the record of the given property. However, the Notary Registry is not intended to record all movable property in the country (which would be an impossible task), but only for record charges. As long as a movable property is not charged by a non-possessory charge, that property is not registered.

A search in a property - based registry can be made under the specifics of the property itself, while in the Notary Registry a search can only be made under the name of the person who was the owner of that property at the time when the charge was created. There is no legislation (and as the registry is not property based, it is probably not possible to create such legislation) which would ensure that a change in the ownership of the collateral is reflected in the Notary Registry, i.e. that the charge is registered under the name of the new owner.

The general rule is that any transfer of, and any further charge over, charged property is subject to the charge. Any buyer or chargee is expected to investigate the Notary Registry and is deemed to be aware of any registered charge. Since the Registry does not automatically show the changes in the ownership of the charged assets, it may happen that, the charge will not be registered under the name of the new owner of the charged property and thus a bona fide purchaser will not be able to find the property in the Registry. We cannot answer the question whether in such a situation the charge is effective towards bona fide third parties who are not able to recognise that the property is already charged. Although the charge agreement may oblige the chargor to inform the chargee about any change in the ownership of the collateral or even may prohibit any such change, the breach of such provision by the chargor may deprive the chargee of its security if a bona fide third party could acquire the property free of charge.

The users of the Notary Registry have always to be aware of its limits rooted in the nature of the Registry. We have to accept and learn to live with the fact that the registry of charges over movables cannot be perfect. This should have an impact on the provisions of the implementing decree of the Notary Registry. It seems evident that the same legal effect should not be attributed to the Notary Registry as to the property-based registries.

As there are two types of non-possessory registered charges and both are registered in the Notary Registry, it is important to emphasize the difference between the two. The charge which we are dealing with here is non-possessory registered charge over individually specified movable assets which the charger is not entitled to replace with similar ones. The subject of this charge are assets which usually remain in the possession of the chargor; that is, in the course of its ordinary business the charger does not sell, process or combine those (e.g. machines, trucks, cars and other durable goods). If the chargor nevertheless sells the charged asset, the asset will remain encumbered with the charge. Non-possessory charge over stock in trade and other circulating assets (including cash) can be created in the form of enterprise charge.

Enterprise charge

An important novelty of the Act is that not only individually identified properties but also a pool of assets which is all or part of the assets of an enterprise can also serve as collateral ("vagyont terhelõ zálogjog"). The enterprise charge allows the charger not only to posses and use but also to sell the charged assets free of the charge in the ordinary course of its business to a purchaser who acts in good faith. This charge allows the natural circulation of the charged assets, thus allowing the chargor to continue its business and generate income through the use and sale of those assets.

The fact that the collateral is a pool of assets, in which the individual assets are continuously changing, increases the risks of the chargee. In order to protect the creditors' interests in such a situation, there are additional provisions in the Act:

  • Any new asset which falls in the description of the property covered by the enterprise charge will automatically become subject to the enterprise charge.
  • If a decrease in the value of the charged property endangers the creditor's right of satisfaction, the chargor is obliged to inform the creditor.
  • If the parties so agree, the creditor may monitor and supervise the chargor’s business activity.
  • The creditor, by notifying the chargor, may convert the enterprise charge into a charge over specifically determined assets even before the underlying obligation becomes due, if any loss or impairment in the charged property jeopardizes its rights under the security.
  • Any purchase price paid to the chargor as consideration for the sold assets will become subject to the enterprise charge. (In our view this provision is to be applied only in cases the charger does not replace the sold assets with new ones as it would be natural in a going concern. Even in such cases the money will only be the subject of a general enterprise charge.)

As noted above, the enterprise charge has to be registered in the Notary Registry in the same way as a non-possessory charge over specified assets, with the significant difference that in the case of the enterprise charge the charged assets are not individually specified in the registry. When an enterprise charge covers all of the chargor’s assets the collateral is simply defined by a reference to this fact. If, however, the charge covers a part of the chargor’s assets, it is necessary to describe the collateral by using characteristics which identify the charged assets with appropriate certainty.

The subject of enterprise charge can be any kind of property, not only movables but also immovables and intangibles. It raises the question whether it is enough to register an enterprise charge only into the Notary Registry or whether it has to be registered in the appropriate property registry as well. With respect to immovables there are conflicting provisions in the Act. An enterprise charge, irrespective the nature of the charged assets has to be registered in the Notary Registry, but at the same time a charge over immovables, irrespective of the type of charge can only be created by registering that charge into the Land Registry. It seems that the enterprise charge can be established by registering it into the Notary Registry, but it can be enforced only if it is crystallized and the charge is registered in the relevant registry.

It means that in strict legal terms (at least in the traditional continental sense of a mortgage or similar charge) an enterprise charge is not an actual charge but a contingent one which can become actual in certain circumstances by converting it into a fix charge. It is this contingent nature of the charge which makes the circulating of the charged assets possible. This approach, however, is not consequently applied in the act. As we already mentioned, there are two conjunctive conditions which both have to be met in order to acquire the ownership of an asset which belongs in the charged pool free of the charge. The sale has to be within the ordinary course of the chargor’s business and the buyer has to act in good faith. Otherwise the purchased goods will be encumbered with the charge in the same way as in the case of a registered charge over specific assets. This provision, though advantageous to chargees, may disrupt commerce because buyers may not know whether a sale is in the ordinary course of the seller’s business as the buyer may not know the background and motives of a sale. Even if he does, in many cases it is not easy to judge whether the circumstances take the transaction out of the ordinary course of business.

According to the Act, although the conversion of an enterprise charge into a charge upon specific items happens upon the chargee's declaration addressed to the chargor, it will not have an effect on third parties until every item is specified individually and registered in the appropriate registry or taken into possession. (The practical effects are not clear yet.) However, as there is no any rule regarding the consolidation of the different registries and the legislation on the registries was not amended to provide for registration of an enterprise charge, it seems that when an enterprise charge is turned into a fix charge it will be registered at the rank available on the registration date.

Therefore, if a charge was created (and thus registered) to a third party on the property after the creation of the enterprise charge but prior to its conversion into a specific charge, the third party has priority over the converted enterprise charge. This rule fits into the contingent nature of the enterprise charge, but conflicts with the general rule that all charges and not only charges of the same type, rank according to the date of their creation.

Though it may be tempting to include all assets of the debtor into a general enterprise charge, risk-conscious creditors will have to consider carefully whether its advantages outweigh the uncertainties described above.

Charge over intangibles

However liberal and unitary the new law may be, it cannot make possible to possess property which is intangible. This means that intangible assets, although are not explicitly excluded from any type of charge (registered or possessory), form a special group of collateral.

While possession of intangibles is not possible, it is possible to possess the document together with a notification to the obligor which thereby is similar to possession of tangibles. Formerly, a charge over transferable rights could only be created by taking the documents into possession and giving notification to the obligor of the underlying obligation. Under the Act, neither the possession of the documents nor notice to the obligor is necessary for the creation of the charge, only to its enforcement. Hence the question arises of how a charge on intangibles be created. There are two possible answers: (i) by simply entering into a charge contract; or (ii) based on a charge agreement, by registration of the charge in the Notary Registry. If a charge over intangibles belongs to the group of non-possessory registered charges (jelzálogjog) it has to be registered. If, however, it is a third type of charge (beside possessory charges and registered charges) it cannot be registered. At this moment it is unclear which is the right answer.

As mentioned above, a charge over patents is registered separately in the Patent Registry. Ownership interest in a limited liability company or a joint stock company is registered in a share registry kept by the companies. In most cases charges over ownership interests in a company (which can be possessory charges if share certificates are issued, as they are considerated to be tangibles) are registered in the share registry. This is a useful practice because purchasers or creditors can get some information from the share registry on charges. It is, however, important to note that this registration does not have the same legal effect as, for example, the property registries or the Notary Registry.

Reserved place in ranking

If several registered charges encumber the same property, the creditor whose security was registered earlier is entitled to receive satisfaction from the charged property prior to those whose charges were created later. The registration operates under the principle of moving ranking, meaning that whenever a charge is deleted, each charge behind the deleted one steps forward one position.

In the future, however, as a result of the re-emergence of a pre-war rule, when a registered charge terminates, the owner of the charged property will be entitled to create a new charge in favour of either the former chargee or a third person in place of and to the extent of the former charge. The owner, if does not wish to create a new charge immediately, can reserve the rank of the deleted charge for a period of one year and take advantage of this ranking later. The rule allows the chargor to prevent existing registered charges from moving ahead, which could mean that a second ranking charge might never become first ranking. An important characteristic of the rule is that the charger may only waive this right for the benefit of a third party, but not for the benefit of the chargee.

Independent charge

As a general rule, the purpose of a charge is to secure an underlying claim and the charge ceases to exist when the underlying claim is performed or otherwise terminated. According to the Act, however, a so called independent charge can be created without an underlying claim, or without a discharge of a previously existing claim. The wording of the Act is somewhat misleading, because, like in any other form of charges, there is a debt in cases of an independent charge. This debt, however, is not a separate one and is incorporated in the charge document. Similarly, with a promissory note or a bill of exchange, where the maker or drawer does not describe the basis and conditions of the debt, the independent charge only describe the amount which is secured by the charge.

A major characteristic of the independent charge is that the charger will not be personally liable for the debt; that is, he will not be liable with any of its properties other than the charged one. To enforce an independent charge, it has to be terminated. The charge may include notice period or other limitation on the termination. In the absence of such a provision, a six-month notice period will apply. A further similarity to negotiable instruments is that in order to make independent charge easily transferable, the chargor is not entitled to raise objections from the underlying obligation against a bona fide transferee who gave value in exchange for the charge. The subject of an independent charge may be any type of property and the charge can be either possessory or registered. At the moment there are many questions as to the real content and practical applicability of this new instrument.

Enforcement mechanisms

Under the new legislation, the following new ways of enforcement have become available in addition to the conventional court enforcement:

  • If the security contract is in a notarized document, the court will issue an execution warrant on the basis of the said document without the need of an extensive judicial proceeding. (This could become the general rule instead of the court enforcement, as creation of both non-possessory registered charges on movables and enterprise charges requires a notarized document.)
  • The parties may agree to sell the collateral jointly. Such an agreement is valid only if: (a) it is concluded at a time when the chargee's right to foreclosure has already opened; and (b) it defines the minimum purchase price and a deadline for the completion of sale.
  • The parties may agree in writing, even before the chargee's right to foreclosure opens, that the chargee may sell the collateral if: (a) the charged property has an officially quoted market price; or (b) it is part of the chargee's normal business activity to lend money on security. "Lending money on security" and "officially quoted market price" are not yet defined in Hungarian law.
  • Even if none of the conditions laid down in the previous paragraph are met (i.e. it is not part of the chargee's business to lend money on security and the collateral does not have an officially quoted market price), the parties may agree that the creditor can give a mandate to a person whose business is organizing auctions or lending money on security to sell the charged property.

In evaluating the effects of the above provisions one has to take into consideration that at the moment the practice of private enforcement and of auctions hardly exists. It will need some time until the practice and ethics of this business properly develops.

Transitional period

The amendment came into force on 1 May, 1996. The implementation of the two most important new institutions, however, requires a longer period. The Notary Registry will start to operate on 1 May, 1997, and thus the provisions on enterprise charges and registered charges over movables will also be effective from 1 May, 1997, allowing the application of the special rules on non-possessory charges to banks until 30 April, 1997.

The new law will apply to charges created after the relevant provisions came into effect. This means that, even after 1 May, 1997, we may find unregistered non-possessory charges for the benefit of banks, granted under the former rules, which enjoy or at least claim priority over charges registered in the Notary Registry. This would jeopardise the main purpose of the registration system as a reliable source of information on non-possessory charges. Considering, however, that the new system provides stronger security to creditors than the former one, we hope that the banks will replace their charges with new ones which meet the requirements of the Act.

In spite of the concerns described above, the Act undoubtedly is a development of the Hungarian law on security interests. Many further steps are, however, still ahead of us. The government has to issue the implementing decree on the Notary Registry; the Chamber of Notaries has to make sure that the Notary Registry is set up in time and that it will operate as expected; and last but not least, practising lawyers must contribute to the development of an efficient and reliable system of security interests.