Effectiveness of a Contradicting Second Ranking Pledge

Dear clients and friends,

On January 28, 2014, the Supreme Court (the Hon. Chief Justice A. Grunis, J., the Hon. Y. Danziger, J., and the Hon. D. Barak-Erez, J.) ruled in Civil Discretionary Appeal 8574/13 Yaron Levy v. The Estate of the Late Freddie Zanzuri.  The main questions discussed by the Supreme Court were whether a second ranking pledge, which was entered into in violation of the terms of a first ranking pledge, is nevertheless valid and enforceable against the pledgor; and whether such pledgor may contest the validity of the second ranking pledge if the beneficiary of the first ranking pledge does not.

The case involved a long term leaseholder of a property that was subject to four different pledges in favor of a bank.  Each of the four pledges contained a restrictive clause prohibiting the creation of additional pledges on the property without the bank’s consent. Several years after the creation of these four pledges, the owner of the property received a loan from another party (the “Lender”), which was coupled with a security interest – an additional pledge on the property, securing the loan.  The parties did not receive the bank’s consent for the creation of this pledge, in violation of the aforementioned restrictive clause.

When the owner of the property failed to repay the loan to the Lender, and pursuant to the Lender’s intention to exercise its pledge on the property, the bank foreclosed on the property.  The owner of the property argued, based on an interpretation of Section 6(a) of the Israeli Pledges Law, 5727-1967 (the “Law”), that the pledge that was created in favor of the Lender is void, as it was created without the bank’s consent and in violation of the terms of the preceding pledges.

Section 6(a) of the Law permits the creation of a subsequent pledge without the prior consent of a party in favor of whom an earlier pledge was created, except if the earlier pledge states otherwise.

The Supreme Court held that if the terms of an earlier pledge restrict the creation of subsequent pledges, any such subsequent pledges are void; however, when the beneficiary of the earlier pledge consents – prospectively or retroactively – to the creation of a subsequent pledge that is inferior to its own earlier pledge, such subsequent pledge is valid and effective.

The Supreme Court ruled that the Law protects the earlier pledge from any sequential secured creditors that wish to foreclose on the pledged property in a manner that is harmful or otherwise derogates from the security interest of the beneficiary of the earlier pledge; however, such protection is not applicable to the pledgor, who willingly pledged its property in favor of the beneficiary of the subsequent pledge(s).  Thus, when a subsequent pledge is created in violation of the terms of the earlier pledge, it shall nevertheless be fully effective against the pledgor, unless challenged by the beneficiary of an earlier pledge, and the pledgor is estopped from contending otherwise.

A claim regarding the validity of a subsequent pledge may only be raised by a beneficiary of an earlier pledge, whose interest is the one protected by the Law. Unless such a claim is raised by the beneficiary of an earlier pledge, any subsequent pledge is valid and enforceable against the pledgor, although inferior to the earlier pledge.

This Supreme Court ruling is consistent with the requirement to act in good faith while conducting business and is in line with the estoppel doctrine, which prevents a pledgor from abusing its rights by waiving legal obligations towards the beneficiary of a subsequent pledge, who may legitimately rely on its security interest.

This publication provides general information and should not be used or taken as legal advice for specific situations, which depend on the evaluation of precise factual circumstances.


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