Enforcement of Pledges of Shares and Participatory Interests.
The laws regulating pledges and their enforcement changed in 2009 and, with respect to share pledges, these changes were significant. Goltsblatt’s Ekaterina Dedova explains why.
A pledge of shares or participatory interests is recognized as an efficient way of securing the performance of obligations. In practice, however, until recently, Russian law provided only the terms for pledges in general and said virtually nothing about pledges of shares and participatory interests.
Yet the economic environment has required an effective mechanism for securing creditors’ rights, and pledges have always appeared to be the most popular and straight forward of such mechanisms. The reality now is that the last hope of creditors to get back loaned funds (once all the other debtor’s property has already been sold) is to turn to pledged shares or participatory interests. And so accordingly, below we outline some of the main changes in the pledge legislation that have come into effect this year.
The Old Rules.
First let us take a look at the old rules that provided for two methods of pledge enforcement: court proceedings and out-of-court procedures. Court proceedings were time-consuming and difficult: hearings could last ages; and even once an enforcement decision was obtained in a given case, the story would not end here. The creditor would have to go through a complicated auction procedure and only then would be entitled to get its money back, once the pledged property was successfully sold.
The other method of pledge enforcement was an out-of-court procedure, though this was merely mentioned in the Civil Code without any broad specification. The creditor’s status and its rights with respect to the pledged securities remained unclear; and this uncertainty created legal grounds for challenging the execution of the out-of-court procedure in virtually one hundred percent of the cases. The risks of ending up with a court trial, irrespective of the chosen way of pledge enforcement, reduced the popularity of pledges in general and the pledge of shares and participatory interests in particular.
Moreover, concerning pledges of participatory interests in an LLC, the lack of regulation on pledge enforcement was combined with primitive legislation on LLCs, engendering the risk of loosing the pledged participatory interests. The fact that a transfer of the right to a participatory interest was not subject to any official procedure and required only the signing of a simple share-purchase agreement made it possible to backdate a sale of participatory interests. This meant that even if you signed a pledge agreement for a participatory interest in an LLC, your debtor could act in bad faith and backdate the sale of the pledged shares to any third person, who would then challenge the pledge agreement on the basis of the pledger not being entitled to sign it and thus encumber the participatory interest.
There were other problems connected with the old rules on pledge enforcement. For instance, since pledged assets had to be sold by auction, in most cases the creditor could not simply acquire the rights to the pledged securities. Moreover, the purchaser of acquired shares often faced difficulties in registering its rights in the shareholders’ register of a joint-stock company because there is a strict procedure by which a new title can be registered only when the transfer deed, signed by the pledger, is presented. There also was no legal mechanism for protecting the share purchaser if the pledger refused to sign the deed of transfer.
As I’ve mentioned, a pledge of a participatory interest was not subject to registration, and in conjunction with the primitive procedure for participatory interest transfer, this created many opportunities for wrongful and unfair actions on the part of the pledger.
The New Rules.
The new rules on pledge enforcement now substantially specify and detail the procedure, and moreover, they liberalize the enforcement of pledged shares and participatory interests. To begin with, as of 2009, the circumstances that were required for a pledge to be enforced were stated precisely. When the amount of the current debt exceeds the value of the pledged property by 5 percent, or when the debtor is in default for more than three months, the creditor is entitled to enforce the pledge in court or by out-of-court procedures. The only restriction here is if the pledgee pledger is an individual: in this case, the pledge can be enforced only through preliminary court procedures.
If the pledger is a legal entity, the out-of-court procedure may apply. In this respect, furthermore, the new law provides a clear and straightforward way to enforce a pledge of shares. In the event of default, the pledgee notifies the pledger of the initiation of the enforcement procedure. Such notification should describe the pledged shares or participatory interest, state the amount of the debt due to the creditor, the way the pledged shares should be sold, and the starting (reserve) price for the sale of the pledged property. After the time period indicated in the pledge agreement, the property can be sold.
The creditor (pledgee) is entitled to keep the pledged property and transfer the title to the shares or participatory interest to itself or sell the pledged property. This sale can be by public auction, by commission contract (normally in this case, a commissioner is determined in advance in the pledge agreement), or the pledgee has the right to sell the pledged property directly to a third party. There is, however, one limitation on listing shares: they can only be sold on the stock exchange.
As we can see, the current law on pledges has filled a lot of gaps in the pledge regulation, making this institution more attractive for creditors by increasing the protection of their rights. Yet there are still problems that creditors might face during the enforcement of pledges of shares and participatory interests.
The problem of securing rights to shares or participatory interests remains, for example. In the case of shares, the title to them is obtained only from the time when a relevant entry is made in the shareholders’ register, and the registrar can make this entry only upon presentation of the set of documents provided for by law. These documents include the so-called deed of pledge that must be signed by the pledger, otherwise the transfer of the title to the creditor would be obstructed. As for a participatory interest, the pledge agreement itself should be notarized, with the notary applying to the registration authority for an entry to be made on the participatory interest encumbrance in the State Register of Legal Entities. In this respect, it is still unclear how the transfer of a participatory interest to a third party by auction or to the creditor will be set up and when the rights will be deemed as transferred.
Another obstacle in the case of a participatory interest pledges is an agreement by other participants in the LLC to transfer the participatory interest to the auction winner. Since the transfer of a participatory interest to the auction winner or any third party (under a commission agreement) is conditional, a pledge of participatory interests can be less attractive to creditors. On the other hand, a pledge and transfer of title to participatory interests has to be notarized, thereby giving additional protection to the creditors’ interests.
The law on pledge in its current version provides for the independent evaluation (appraisal) of shares and participatory interests if their price exceeds half a million rubles. The law requires such an appraisal, however, only if the shares are sold by an out-of-court procedure, which does not, of course, include the withholding of shares and participatory interests and transfer of the rights thereto directly to the pledgee. The need for an independent appraisal thus appears at least arguable in this case.
The other issue with participatory interests is the possibility of applying out-of-court procedures to participatory shares owned by an individual. The Civil Code stipulates the need for court proceedings if the signing of the pledge agreement required approval by any third party. The general rule is that the pledge of a participatory interest is subject to the preliminary approval of other participants in an LLC. Thus, at first glance, this requirement prohibits the implementation of out-of-court procedures in the case of a pledge of participatory interests. On the other hand, the new version of the relevant article of the Civil Code refers to court procedures only with respect to the pledge of an individual’s property. We should always keep in mind, therefore, that if the pledger of a participatory interest is an individual and not a legal entity, this pledge can be enforced only through a court of law.
Another question of importance is the pledge of a participatory interest in connection with the right of the participant to withdraw from the company. The current legislation on LLCs in general prohibits any withdrawal by a participant from a company, yet participants can prescribe the right to do so in the company charter. In this case, the participant can demand payment of the actual value of its participatory interest and leave the company, with the subsequent transfer of its participatory interest to the company. The fairness of this right is arguable, but what is important to note is that this possibility of withdrawing makes the pledge of participatory interests virtually pointless, because the participant has strong legal grounds for leaving the company at any time and withdrawing the economic value of its share. The company is then left with the pledged participatory interest and has to sell it within one year or reduce the charter capital. For the time being, the only remedy for minimizing this risk is to review the company’s charter before signing the pledge agreement. Yet even this is not a one-hundred-percent guarantee, since the charter of the company can be amended at any time by decision of the participants.
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