Financial security within corporate law

For entrepreneurs, obtaining financial security is very important. When you enter into an agreement with another party, you want to make sure that the counterparty fulfils its contractual payment obligations. If you provide financing or make investments for the benefit of another person, you also want a guarantee that the amount you have provided will eventually be repaid. In other words, you want to obtain financial security. Obtaining financial security ensures that the lender has a collateral when he notices that his claim is not going to be fulfilled. There are various possibilities for entrepreneurs and companies to obtain financial security. In this article, the several liability, escrow, (parent company) guarantee, 403-declaration, mortgage and pledge will be discussed.

Financial security within corporate law

1. Several liability

In the case of several liability, also called joint liability, there is strictly speaking no guarantee that is issued, but there is a co-debtor who assumes responsibility for other debtors. Several liability derives from article 6:6 Dutch Civil Code. Examples of several liability within corporate relationships are the partners of a partnership who are severally liable for the debts of the partnership or the directors of a legal entity that, under certain circumstances, can be held personally liable for the debts of the company. Several liability is often established as security in an agreement between parties. The rule of thumb is that, when a performance deriving from an agreement is due by two or more debtors, they are each committed for an equal share. They can therefore only be obligated to fulfil their own part of the agreement. However, several liability is an exception to this rule. In the case of several liability, there is a performance that has to be performed by two or more debtors, but where each debtor can individually be held to perform the entire performance. The creditor is entitled to fulfilment of the entire agreement from every debtor. Therefore, the creditor can choose which of the debtors he wishes to address and can then demand the full amount due from this one debtor. When one debtor pays the entire amount, the co-debtors do not owe the creditor anything anymore.

1.1 Right of recourse

The debtors are internally liable to pay each other, so the debt that was paid by one debtor must be settled among all debtors. This is called the right of recourse. The right of recourse is the right of a debtor to reclaim what he has paid for another who is liable. When a debtor is severally liable for paying a debt and he pays the full debt, he obtains the right the recover this debt from his co-debtors.

If a debtor no longer wishes to be severally liable for the financing he has entered into together with other debtors, he may request the creditor in writing to discharge him from the several liability. An example of this is the situation where a debtor has entered into a joint loan agreement with a partner, but wishes to leave the company. In this case, a written dismissal of several liability must always be drawn up by the creditor; an oral commitment from your co-debtors that they will pay the debts is not sufficient. If you co-debtors cannot or do not fulfil this oral agreement, the creditor can still claim the entire debt from you. 

1.2. Requirement of consent

The marital or registered partner of the debtor who is severally liable is protected by law. According to article 1:88 paragraph 1 sub c Dutch Civil Code, a spouse requires consent from the other spouse to enter into contracts that are binding on him as severally liable co-debtor, other than in the normal business activities of a company. This is the so-called requirement of consent. This article intents to protects spouses from legal actions that may entail a major financial risk. When a creditor holds a co-debtor severally liable for the entire claim, this can also have consequences for the spouse of the co-debtor. However, there is an exception on this requirement of consent. According to article 1:88 paragraph 5 Dutch Civil Code, consent is not required when the director of a public limited liability company or a private limited liability company (Dutch N.V. and B.V.) entered into an agreement, while this director is, alone or together with his co-directors, owner of the majority of the shares and if the agreement was concluded on behalf of the normal business activities of the company.  In this, there are two requirements that need to be fulfilled: the director is managing director and majority shareholder or owns a majority of the shares together with his co-directors ánd the agreement was concluded on behalf of the normal business activities of the company. When these requirements are not both met, the requirement of consent applies.

2. Escrow

When a party requires security that a monetary claim will be paid, this security can also be provided by escrow.[1] Escrow derives from article 7:850 Dutch Civil Code. We speak of escrow when a third party commits himself to a creditor for a commitment that another party (the principal debtor) has to fulfil. This is done by concluding an escrow agreement. The third party that provides security, is called the guarantor. The guarantor assumes an obligation towards the creditor of the principal debtor. The guarantor therefore does not accept liability for a debt of his own, but for the debt of another party and personally provides security for the payment of this debt. The guarantor is liable with his entire assets. An escrow can be agreed for fulfilment of obligations that already exist, but also for the fulfilment of future obligations. Pursuant to article 7:851 paragraph 2 Dutch Civil Code, these future obligations must be sufficiently determinable at the moment the escrow is concluded. If the principal debtor cannot fulfil his obligations deriving from the agreement, the creditor can address the guarantor to fulfil these obligations. According to article 7:851 Dutch Civil Code, the escrow is dependent from the obligation of the debtor for which purpose the escrow was concluded. Therefore, the escrow ceases to exists when the debtor has fulfilled his obligations deriving from the principal agreement.

A creditor cannot simply address the guarantor to pay the debt. This is because the so-called principle of subsidiarity plays a role in escrow. This means that the creditor cannot immediately appeal to the guarantor for payment. First of all, the guarantor may not be held liable for payment before the principal debtor has failed in the fulfilment of his obligations. This derives from article 7:855 Dutch Civil Code. This means that a guarantor can only be held liable by the creditor after the creditor has first addressed the principal debtor. The creditor must have done everything necessary to establish that the debtor, for whom the guarantor has committed himself, failed to fulfil his payment obligation. In any case, the creditor must send a notice of default to the principal debtor. Only if the principal debtor still fails to comply with the payment obligation after receiving this notice of default, the creditor can appeal to the guarantor to obtain payment. However, the guarantor also has the possibility to defend himself against the claim of the creditor. To this end, he has the same defences at his disposal that the principal debtor has, such as suspension, remission or an appeal on non-conformity. This derives from article 7:852 Dutch Civil Code.

2.1 Right of recourse

A guarantor who pays the debt of a debtor, can reclaim this amount from the debtor. The right of recourse therefore also applies to escrow. In escrow, a special form of the right of recourse applies, namely subrogation. The principal rule is that a claim ceases to exist when the claim is paid. However, subrogation is an exception to this rule. In subrogation, a claim is transferred to another owner. In this case, another party than the debtor pays the claim of the creditor. In escrow, the claim is paid by a third party, namely the guarantor. By paying the debt, however, the claim against the debtor is not lost, bus is transferred from the creditor to the guarantor who paid the debt. After payment of the debt, the guarantor can therefor go and recover the amount from the debtor for whom he has entered into an escrow agreement. Subrogation is only possible in cases that are regulated by law. Subrogation with regard to escrow is possible on the basis of article 7:866 Dutch Civil Code jo. article 6:10 Dutch Civil Code.

2.2 business and private escrow 

There is a difference between business and private escrow. Business escrow is an escrow that is concluded in the exercise of a profession or business, private escrow is an escrow that is concluded outside the exercise of a profession or business. Both a legal entity and a natural person can conclude an escrow agreement. Examples of this are the holding company that concludes an escrow agreement with the bank for the financing of its subsidiary and the parents who conclude an escrow agreement to ensure that payment of the mortgage interest by their child is made to the bank. An escrow does not always have to be concluded on behalf of a bank, it is also possible to enter into escrow agreements with other creditors.

Most of the time it is clear whether a business or a private escrow was concluded. If a company enters into an escrow agreement, a business escrow is concluded. If a natural person enters into an escrow agreement, there is generally a private escrow concluded. However, ambiguity may occur when a director of a public limited liability company or a private limited liability company concludes an escrow agreement on behalf of the legal entity. Article 7:857 Dutch Civil Code entails what is meant by private escrow: the concluding of an escrow by a natural person who did not act in the exercise of his profession, nor for the normal practise of a public limited liability company or private limited liability company. Also, the guarantor must be the director of the company and, alone or with his co-directors, own the majority of the shares. There are two criteria that are important:

– the guarantor is the managing director and majority shareholder or owns the majority of the shares together with his co-directors;
– the escrow is concluded on behalf of the normal business activities of the company.

In practise, there is often a managing director / majority shareholder who enters into an escrow agreement. The managing director / majority shareholder determines the policy of the company and will have a personal interest in the escrow for his company, because it may be possible that the bank does not want to provide financing without concluding an escrow agreement. In addition, the escrow agreement, concluded by the managing director / majority shareholder, must also have been concluded for the purpose of normal business activities. However, this is different for each situation and the law does not define the term ‘normal business activities’. In order to assess whether an escrow is concluded for the purpose of normal business activities, the circumstances of the case must be examined. When both criteria are met, a business escrow is concluded. When the director who concludes the escrow is not the managing director / majority shareholder or the escrow was not concluded for the purpose of normal business activities, a private escrow is concluded.

Additional rules apply to private escrow. The law provides protection for the marital or registered partner of the private guarantor. The requirement of consent namely also applies to private escrow. According to article 1:88 paragraph 1 sub c Dutch Civil code, a spouse needs consent of the other spouse to enter into an agreement that intends to bind him as a guarantor. The consent of the spouse of the guarantor is therefore required for entering into a valid private escrow agreement. However, article 1:88 paragraph 5 Dutch Civil Code entails that this consent is not required when the escrow is concluded by an business guarantor. The protection of the spouse of the guarantor therefore only applies to private escrow agreements.

3. Guarantee

A guarantee is another possibility to obtain security that a claim will be paid. A guarantee is a personal security right, where a third party assumes an independent obligation to fulfil a commitment between the creditor and the debtor. A guarantee therefore entails that a third party guarantees the fulfilment of the obligations of the debtor. The guarantor undertakes to pay the debt if the debtor cannot or will not pay.[2] The guarantee is not regulated by law, but a guarantee is concluded in an agreement between parties.

3.1. Accessory guarantee

A difference can be made between two forms of guarantees in order to obtain security; the accessory guarantee and the abstract guarantee. An accessory guarantee is dependent from the relationship between the creditor and the debtor. At first sight, the accessory guarantee is very similar to the escrow. However, the difference is that the guarantor with regard to an accessory guarantee does not commit himself to the same performance as the principal debtor, but to a personal obligation with a different context. A simple example of this is when the guarantor commits himself to deliver tomatoes to the creditor, if the debtor does not fulfil his obligation to deliver potatoes. In this case, the content of the guarantor’s obligation is different from the content of the obligation of the debtor. However, this does not detract from the fact that there is a great affiliation between the two commitments. The accessory guarantee is additional to the relationship between the creditor and the debtor. Moreover, the accessory guarantee will often have the function of a safety net; only when the principal debtor does not fulfil his obligations, the guarantor is called upon to perform his commitment.

Although the guarantee is not explicitly mentioned in the law, article 7:863 Dutch Civil Code does implicitly refer to the accessory guarantee. According to this article, the provisions relating to private escrow also apply to agreements where a person commits to a particular service in the event that a third party fails to comply with a particular obligation with a different content towards the creditor. The provisions with regard to private escrow therefore also apply to the accessory guarantee that is concluded by a private person.

3.2 Abstract guarantee

In addition to the accessory guarantee, we also know the financial security of the abstract guarantee. Unlike the accessory guarantee, the abstract guarantee is an independent commitment of the guarantor towards the creditor. This guarantee is impartial from the underlying relationship between the creditor and the debtor. In the case of an abstract guarantee, the guarantor commits himself to an independent obligation to execute a performance for the debtor, under certain conditions. This performance is not tied to the underlying agreement between the debtor and the creditor. The best-known example of the abstract guarantee is the bank guarantee.

When an abstract guarantee is concluded, the guarantor cannot invoke defences from the underlying relationship. When the conditions for the guarantee are met, the guarantor cannot prevent payment. This is because the guarantee derives from a separate agreement between the creditor and the guarantor. This means that the creditor can immediately address the guarantor, without having to send a notice of default to the debtor. By concluding a guarantee, the creditor therefore obtains a high degree of certainty that the debt is paid to him. In addition, a guarantor does not have a right of recourse. However, parties can include protective measures in the guarantee agreement. The legal effects of an abstract guarantee do not derive from statutory regulations, but can be filled in by the parties themselves. Although the guarantor has no right of recourse under the law, he can provide for means of recovery himself. For example, a counter guarantee can be concluded with the debtor or a deed of indemnity can be drawn up.

3.3 Parent company guarantee

In company law, a parent company guarantee is often concluded. A parent company guarantee entails that a parent company commits itself to comply with the obligations of a subsidiary of the same group if the subsidiary itself does not or cannot meet these obligations. Of course, this guarantee can only be agreed upon with companies that are part of a group or holding company. In principle, a group guarantee is an abstract guarantee. However, normally there is no ‘first pay, then talk’ concept, whereby the guarantor immediately pays the debt without checking in substance whether there exists a demandable  claim against the debtor. The reason for this is that the debtor is the subsidiary of the guarantor; the guarantor will want to check first if there is indeed a demandable claim. Nevertheless, a ‘first pay, then talk’ construction can be built into a guarantee agreement. After all, parties can structure the guarantee according to their own wishes. The parties must also determine whether the guarantee only encompasses a payment guarantee or whether the guarantee must also cover other obligations, and is therefore a performance guarantee. The scope, duration and conditions of the guarantee are also determined by the parties themselves. A parent company guarantee can provide a solution when the subsidiary goes bankrupt, but only if the parent company does not collapse together with its subsidiaries.

4. 403-statement

Within a group of companies, a so-called 403-statement is also often issued. This statement derives from article 2:403 Dutch Civil Code. By issuing a 403-statement, the subsidiaries belonging to the group are exempt from drafting and publishing separate annual accounts. Instead, a consolidated annual account is drafted. This is the annual account of the parent company, in which all the results of the subsidiaries are included. The background of the consolidated annual account is that all subsidiaries, although often operating relatively independently, ultimately fall under the management and supervision of the parent company. A 403-statement is a unilateral legal act, from which an independent commitment for the parent company arises. This means that the 403-statement is a non-accessory commitment. A 403-statement is not only issued by large international groups; small groups, for example consisting of two private limited liability companies, can also make use of a 403-statement. A 403-statement must be registered within the Trade Register of the Chamber of Commerce. This statement indicates which debts of the subsidiary are covered by the parent company and from which date.

The other side of the 403-statement is that the parent company with this statement declares that it is responsible for the obligations of its subsidiaries. The parent company is therefore severally liable for the debts arising from legal acts of the subsidiaries. This several liability entails that a creditor of the subsidiary for which a 403-statement was issued may choose which legal entity he wants to address for fulfilment of his claim: the subsidiary with which he has concluded the primary agreement or the parent company that issued a 403-statement. With this several liability, the creditor is compensated for the lack of insight into the financial position of the subsidiary that is his counterparty. Whereas the aforementioned financial securities only entail liability towards the counterparty with whom the contract is concluded, the 403-statement creates liability towards all creditors of the subsidiaries. There may be more creditors who can address the parent company for fulfilment of their claims. The potential liability that derives from the 403-statement is therefore substantial. A disadvantage of this is that a 403-statement may affect the entire group when a subsidiary faces financial problems. If a subsidiary goes bankrupt, the entire group may collapse.

4.1 Revocation of a 403-statement

It is possible that a parent company no longer wishes to be liable for the debts or its subsidiaries. This may be the case when the parent company wants to sell the subsidiary. In order to withdraw a 403-statement, the procedure deriving from article 2:404 Dutch Civil Code needs to be followed. This procedure consists of two elements. First of all, the 403-statement has to be revoked. A declaration of revocation must be deposited at the Trade Register of the Chamber of Commerce. This declaration of revocation entails that the parent company is no longer liable for debts of the subsidiary that arise after the declaration of revocation has been issued. However, according to article 2:404 paragraph 2 Dutch Civil Code, the parent company will remain liable for debts deriving from legal acts that were concluded before the 403-statement was revoked. Liability therefore continues to exist for debts arising out of agreements that were concluded after issuing the 403-statement, but before issuing the declaration of revocation. This is to protect the creditor, who might have entered into an agreement with the certainty of the 403-statement in mind.

However, it is possible to terminate liability with regard to these past legal acts. In order to do this, an additional procedure, deriving from article 2:404 paragraph 3 Dutch Civil Code, must be followed. Several conditions apply in this procedure:

– the subsidiary may no longer be part of the group;
– a notification of the intention to terminate the 403-statement must have been available for inspection at the Chamber of Commerce for at least two months;
– at least two months must have passed since the announcement in a national newspaper that the notice of termination is available for inspection.

In addition, creditors still have the option to oppose the intention to terminate the 403-statement. The 403-statement can only be terminated when no or no timely opposition has been lodged or when a lodged opposition has been declared invalid by a judge. Only when the conditions for both revocation and termination of the 403-statement are met, the parent company is no longer severally liable for any debts of the subsidiary. It is important that this revocation and termination are executed carefully; if the revocation or termination has not been properly executed, a parent company can even be held liable for debts of a subsidiary that has been sold years ago.

5. Mortgage and pledge

Financial security can also be obtained by establishing a mortgage or pledge. While these forms of financial security strongly resemble one another, there are several differences.

5.1. Mortgage

A mortgage is a financial security that parties can stipulate. A mortgage entails that one party provides a loan to another party. Subsequently, a mortgage will be stipulated in order to obtain financial security with regard to the repayment of this loan. A mortgage is a property right that can be established with regard to property of the debtor. If the debtor is unable to repay his loan, the creditor can claim the property in order to fulfil his claim. The best-known example of a mortgage is of course the home-owner who has agreed with the bank that the bank will grant him a loan and then uses his house as security for repayment of the loan. However, this does not mean that a mortgage can only be established via the bank. Other companies and individuals can also conclude a mortgage. The terminology in mortgages may be confusing. In normal speech, a party, for example a bank, provides a mortgage to another party. However, from a legal perspective, the borrower is the mortgage provider, while the party that grants the loan is the mortgage holder. The bank is therefore the mortgage holder and the person who wants to buy a house is the mortgage provider.

Characteristic of a mortgage is that a mortgage cannot be concluded on every property; according to article 3:227 Dutch Civil Code, a mortgage can only be established on registered property. When registered property is sold, this transmission needs to be registered in the public registers. Only after this registration, the registered property is actually obtained by the buyer. Examples of registered property are land, houses, boats and airplanes. A car is not registered property. Furthermore, a mortgage can only be established for the benefit of ‘a sufficiently determinable claim’. This derives from article 3:231 Dutch Civil Code. This means that it must be clear with regard to which claim the mortgage is established. If a creditor has two claims against a debtor, it must be clear with regard to which of these two claims the mortgage right has been granted. Moreover, the owner of the property on behalf of which a mortgage is established remains the owner; the ownership does not pass after the establishment of a mortgage right. A mortgage is always established by issuing a notarial deed.

If the debtor does not fulfil his payment obligations, the creditor can exercise his mortgage right by selling the property on behalf of which the mortgage was established. No court order is required for this. This is called immediate execution and derives from article 3:268 Dutch Civil Code. It is important to keep in mind that the creditor may only sell the property in order to fulfil his claim; he may not appropriate the property. This prohibition is explicitly stated in article 3:235 Dutch Civil Code. An important feature of the mortgage is that the mortgage holder has priority over other creditors who wish to claim the property in order to fulfil their claims. This is according to article 3:227 Dutch Civil Code. During a bankruptcy, the mortgage holder does not have to consider the other creditors, but can simply exercise his mortgage right. He is the first creditor who can fulfil his claim with the profits from the sale of the registered property.

5.2. Pledge

A security right that is comparable to the mortgage is the pledge. Contrary to the mortgage, a pledge cannot be established on immovable property. However, a pledge can be established on practically every other property, such as moveable property, rights to bearer or order and even on the usufruct of such a property or right. This means that a pledge can be established on both cars and on amounts to receive from debtors. A creditor establishes a pledge in order to obtain security that a claim will be paid. An agreement will be concluded between the creditor (the pledge holder) and the debtor (the pledge provider). If the debtor does not comply with his payment obligations, the creditor has the right to sell the property and to fulfil his claim with the profit thereof. When the debtor fails to comply with his payment obligations, the creditor may sell the property immediately. According to article 3:248 Dutch Civil Code, no court order is required for this, which means that immediate execution applies. Similar to the mortgage, the creditor is not allowed to appropriate the property on behalf of which the right of pledge is granted; he may only sell the property and fulfil his claim with the profit. This derives from article 3:235 Dutch Civil Code. In principle, a creditor who has a right of pledge has priority over other creditors in the event of bankruptcy or suspension of payment. However, it may matter whether a possessory pledge or an undisclosed pledge was concluded.

5.2.1 Possessory pledge and undisclosed pledge

A possessory pledge is concluded when the property ‘comes under the control of the pledge holder or a third party’. This derives from article 3:236 Dutch Civil Code. This means that the pledged property is transferred to the creditor; the creditor actually has the property in his possession during the period that the pledge persists. A possessory pledge is established by bringing the good under the control of the creditor. The creditor must take care of the property and possibly conduct maintenance. These maintenance costs must be reimbursed by the debtor.

Besides the possessory pledge, we also have the undisclosed pledge, which is called a non-possessory pledge as well. This is according to article 3:237 Dutch Civil Code. When an undisclosed pledge is established, the property is not brought under control of the creditor, but a deed stating that an undisclosed pledge is established is drawn up. This may be a notarial deed as well as a private deed. However, a private deed needs to be registered at the notary or at the tax authority. Undisclosed pledges are often used by companies that want to establish a pledge on a machine. If the machine was to be brought in the possession of the creditor, the company would be unable to perform its business activities.

A possessory pledge generates a stronger security right than an undisclosed pledge. When a possessory pledge is constituted, the creditor already has the property in his possession. This is not the case when an undisclosed pledge is established. In that case, the creditor must convince the debtor to hand over the property. Is the debtor refuses this, it may even be necessary to enforce transmission of the good through court. The difference between a possessory pledge and an undisclosed pledge also plays a role in bankruptcy and suspension of payment. As has already been discussed, the creditor has the right of immediate execution; he can sell the property immediately in order to fulfil his claim. Also, pledge holders have priority over other creditors within the bankruptcy. However, there is a difference between a possessory pledge and an undisclosed pledge. Holders of a possessory pledge also have priority over the tax authorities when the debtor goes bankrupt. Holders of an undisclosed pledge do not have priority over the tax authorities; the right of the tax authorities prevails over the right of the holder of the undisclosed pledge during bankruptcy of the debtor. A possessory pledge therefore offers more security during bankruptcy than an undisclosed pledge.

6. Conclusion

The above entails that there are several ways to obtain financial security: several liability, escrow, (parent company) guarantee, 403-statement, mortgage and pledge. In principle, these securities are always stipulated in an agreement. Some financial securities can be structured in a form-free manner, according to the wishes of the parties themselves, while other financial securities are subject to legal provisions. As a result, the various forms of financial security all have advantages and disadvantages. This applies to both the party that requires security and the party that provides security. Some financial securities offer more protection to the creditor than other, but may come with other disadvantages. Depending on the situation, an appropriate form of financial security can be concluded between parties.

[1] Escrow is often called guarantee. However, under Dutch law, there are two forms of financial security that translate to guarantee in English. To keep this article comprehensible, the term escrow will be used for this particular financial security.

[2] The term ‘guarantor’ is mentioned both in escrow and in the guarantee. However, the meaning of this term is dependent on the security right involved.

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