Security interests and the suspect period: the risks of cancellation prior to insolvency proceedings

The opening of insolvency proceedings, whether a receivership or compulsory liquidation, marks a difficult turning point for a company and its creditors. But did you know that the effects of these proceedings can go back in time? Acts carried out just prior to the opening of insolvency proceedings, in particular the provision of guarantees (securities), can be called into question. A mortgage or pledge that you thought was solid could suddenly be invalidated.

This critical period, just before the judgment but after the company has stopped making payments, is known as the "suspect period". The law strictly regulates the actions taken during this period to protect the equality of creditors and prevent a beleaguered debtor from favouring some at the expense of others or squandering its assets. It is therefore essential for creditors to understand the risks of annulment that weigh on securities created during this period. We will look at the two main cancellation mechanisms provided for in the French Commercial Code: automatic nullity and optional nullity.

Nullity by operation of law: when the security interest is automatically cancelled (Art. L.632-1 C. com.)

Imagine the unpleasant surprise: the guarantee obtained on your debtor's assets to secure an old debt is declared null and void, simply because it was granted too late, when the company was already in proven financial difficulty. This is the major risk covered by automatic nullity.

The principle: guarantee an old debt with a new security

The fundamental rule laid down by theArticle L. 632-1, I, 6° of the French Commercial Codeis relatively straightforward. Any contractual security in rem (or contractual right of retention) granted by the debtor over his assets during the suspect period is automatically null and void, if it is used to secure a debt incurred during the suspect period. before the creation of this security.

For this nullity to apply, two conditions must be met:

1. The security (mortgage, pledge, collateral, etc.) must have been created after the date set by the court for the cessation of payments.
2. The debt secured by the security must be previous the date on which the security interest itself is created.

For example, a company grants a mortgage to its bank in March to guarantee repayment of a loan taken out in January. If the court later sets the date of cessation of payments at February, this mortgage, although formalised in March, will be void ipso jure because it guarantees a debt (the January loan) that predates its own constitution and was created during the suspect period (after February). It does not matter that the secured debt is not yet due at the time the security is granted.

It is important to note that this regime of nullity of the suspect period does not apply when the company is the subject of safeguard proceedings. Safeguard proceedings are open to a company that is not not in a state of suspension of payments. Logically, therefore, the suspect period does not exist prior to a safeguard judgment.

What securities are involved?

The law takes a broad view to ensure equality between creditors. The Order of 15 September 2021 has also broadened the scope of application. This automatic nullity mainly concerns :

• Conventional sureties : These are all the guarantees granted by contract by the debtor over his assets or rights. This includes conventional mortgages, pledges (with or without dispossession), pledges (of business assets, company shares, equipment, etc.), and even a right of retention granted by contract. A counter-guarantee obtained by a person who has granted an independent guarantee on behalf of the debtor may also be null and void.
• Judicial sureties : Judicial mortgages (obtained following a court decision) or judicial pledges (on business assets, company shares, etc.) registered during the suspect period to secure an earlier debt are also automatically null and void. The law applies even if these securities have been taken against the will of the debtor. The aim is to prevent a creditor from obtaining an unfair advantage during this period, with or without the agreement of the company in difficulty.
• Certain legal securities : Before the 2021 reform, the legal mortgage of spouses was specifically referred to. From now on, it is mainly the legal hypothec attached to sentencing judgments that is expressly mentioned by theArticle L. 632-1, I, 7° of the French Commercial Code. If a judgment condemning the company is obtained during the suspect period and gives rise to a mortgage registration to secure a prior debt, this registration will be null and void. On the other hand, if the judgment is previous at the cessation of payments, the resulting mortgage is valid even if it is not registered until after that date (but before the opening judgment, see the article on the cessation of registrations).

Important exceptions to be aware of

The rule of de jure nullity is not absolute, and there are a number of notable limitations that it is essential to be aware of.

• Warranty substitution : Nullity does not apply if the new security created during the suspect period replaces an earlier one, provided that the new security is not greater in kind or in basis than the one it replaces. L'Article L. 632-1, I, 6°. The idea is that there is no new favour granted to the creditor and no impoverishment for the others if one guarantee is replaced by another equivalent one. For example, a bank that accepts the release of a mortgage on a property sold by the debtor may validly take out a new mortgage on the property acquired in replacement, if its value and nature are comparable. Equivalence is assessed at the time of substitution.
• Dailly assignment of trade receivables : This mechanism (articles L. 313-23 et seq. of the French Monetary and Financial Code), although it can be used as collateral, benefits from a special regime. Case law, now confirmed by law (article L. 632-1, I, 6° in fine), has always tended to exclude it from the scope of legal nullities when it is made by way of security during the suspect period, especially if it is made in performance of a framework agreement signed before cessation of payments. The main argument is that the assignee (usually the bank) only temporarily acquires ownership of the assigned receivables. However, beware: this Dailly assignment may be cancelled if it is used to extinguish a debt that is not yet due or constitutes an abnormal preferential payment during the suspect period.
• Security trust and cash collateral : Initially treated more severely, the trust security is now aligned with other securities. It is automatically null and void only if it was created during the suspect period to secure a prior debt (Article L. 632-1, I, 10°.). The same applies to the recharge of an existing security trust (Article L. 632-1, I, 11°.) or for cash collateral (now known as "assignment of a sum of money as security", Articles 2374 et seq. of the Civil Code). Under no circumstances may a cash pledge constituted after the opening judgment be used to secure prior debts.

Another point of vigilance concerns the ban onincrease the basis of a security interest after the opening judgment (article L. 622-21, IV). Even if the initial security is valid, no new assets or rights can be added to strengthen it once the proceedings have begun (for example, adding securities to a pledged account). This prohibition applies in particular to security trusts, pledges of ordinary accounts and assignments of future receivables. Here again, the Dailly assignment is an exception if it forms part of a previous master agreement.

Optional nullity: when cancellation depends on the creditor's knowledge (Art. L.632-2 C. com.)

Even if a security interest is not automatically null and void (because it guarantees a debt that arose at the same time as the security interest, or because it benefits from an exception such as a Dailly assignment via a framework agreement), it is not definitively safe. It can still be cancelled by the court if certain conditions are met.

The principle: act with full knowledge of the facts

L'Article L. 632-2 of the French Commercial Code allows the court to annul any act "for valuable consideration" carried out during the suspect period (such as the creation of a security interest) if the person who dealt with the debtor (the creditor benefiting from the security interest) was aware of the suspension of payments.

Unlike legal nullity, annulment is not automatic. It is left to the discretion of the judge. The decisive factor is the knowledge by the creditor of the insurmountable difficulties of his debtor at the time he receives the guarantee.

But how do you prove this knowledge? It is not necessary to demonstrate intent to harm or particular bad faith on the part of the creditor. Simple knowledge of the company's irremediably compromised situation is sufficient. Judges make their own assessment of this factual element, which is often deduced from the business relations between the parties (for example, a bank that monitors the company's accounts on a day-to-day basis can hardly be unaware of a sudden and persistent deterioration in cash flow).

Concrete examples of application

Two situations illustrate the application of this optional nullity:

• Mortgage for third parties (or mortgage guarantee) : This is where a person (often a subsidiary or the director) pledges one of his assets as security for the debt of another person (the parent company, for example). This security is not legally null and void because it does not directly guarantee a debt. of the component. However, it may be annulled on the basis of thearticle L. 632-2 if the creditor (the bank) knew that the grantor (the subsidiary) was in a state of suspension of payments at the time the mortgage was taken out on its property. It does not matter whether a prior promise existed.
• Dailly assignment as security : Even though it is often not legally null and void (see above), a Dailly assignment made during the suspect period may optionally be null and void if the transferee bank knew that the transferor was in suspension of payments. Such knowledge may be presumed if the bank has a permanent and ongoing business relationship with the company. However, case law severely restricts this possibility: if the Dailly assignments, even after the cessation of payments, are made in execution of an agreement between the seller and the seller, the seller is deemed to have been aware of the assignment. framework agreement signed before At that date, they are considered to be the performance of a prior agreement and are not subject to optional cancellation. It is the date of the framework agreement that counts.

What should you do if your security interest is disputed?

Challenging a security on the grounds of a suspect period is an action taken by the judicial representative (liquidator or sometimes administrator) on behalf of the collective interest of the creditors. The stakes are high:

• The key date: cessation of payments: The whole discussion is based on the date set by the court for the cessation of payments. This date can itself be the subject of debate and can be pushed back (up to 18 months before the opening judgment, or even more in some cases), which can bring into the suspect period acts that were initially thought to be valid.
• The role of the lawyer : If you are a creditor and the validity of your security is called into question on the basis of the nullities of the suspect period, the assistance of a lawyer familiar with insolvency law is essential. He will be able to analyse whether the conditions for nullity (ipso jure or optional) have been met, check whether there are any exceptions (substitution, Dailly framework agreement, etc.) and, if necessary, challenge the date on which payments ceased.
• The consequence of cancellation : If nullity is declared, the security interest disappears retroactively. The creditor loses his preferential right over the encumbered asset and reverts to being a simple unsecured creditor, sharing the proceeds of the sale of the assets with all other non-preferential creditors on a "pound for pound" basis (i.e. in proportion to the amount of his claim). This considerably reduces the chances of recovery.

The suspect period is therefore a danger zone for guarantees obtained late from a company in difficulty. Anticipating these risks and ensuring the validity of the security taken is an essential part of customer risk management.

If you hold a security interest in a company in difficulty, or if you are concerned that a guarantee you have given may be called into question, an early legal analysis is essential. Contact our firm to assess your situation.

Sources

• French Commercial Code: articles L.632-1, L.632-2, L.622-7, L.622-21, L.622-34
• Civil Code: articles 2374 et seq. (cash collateral/assignment of sums of money), 1413, 1415 (matrimonial property regimes), 2402 et seq. (legal mortgages)
• Monetary and Financial Code: articles L.313-23 et seq. (Dailly assignment)