In Re (#09 September 2012)

Pledge of a Participatory Interest: Problems and Risks

Inna M. Kostrytska

Over the last decade securing obligations by the pledge of a participatory interest in share capital has become more and more popular with Ukrainian banking institutions and business. This is explained not only by the general trend of expansion of the range of assets that can be encumbered or Western tendencies, where such type of the pledge is common, but also by the fact that the pledge of the participatory interest gives more opportunities to obtain credit for many limited liability and additional liability companies the most numerous group of legal entities in Ukraine which is important in a volatile economy.

In many ways participatory interests are treated by the Ukrainian laws like shares in a joint stock company. However, contrary to the shares, which are known as widely used and effective collateral well-regulated by the law, the pledge of the participatory interest is characterized by an absence of clear regulation and potential risks and obstacles for the creditor in the event of enforcement thereof. This article aims to point out problematic issues and evaluate the effectiveness of this subject of pledge.

Subject of pledge: participatory interest vs. corporate rights

Article 576 of the Civil Code of Ukraine defines the subject of pledge as any property (in particular, a thing, securities, property rights) which can be (1) alienated and (2) enforced against.

Neither the participatory interest nor corporate rights arising out of the ownership thereto are specifically named as a subject of pledge in existing legislation. A prerequisite of complications related to the pledge of the participatory interest and corporate rights is ambiguity of their legal nature. In practice, depending on the opinion of the lawyer, you may see any number of descriptions in the subject matter clause of the pledge agreements: pledge of the participatory interest or the right to the portion in the share capital, pledge of corporate rights, pledge of property rights related to the participatory interest, etc.

There exist different theories about the legal nature of participatory interest and corporate rights, and the method of enforcement depends closely on such nature.

The participatory interest may be considered as movable property or, more specifically, if it is seen as the right to the portion in the share capital, as the property rights, which are also covered by the definition of movable property1. It can be sold or alienated in another way along with all rights and obligation arising from it, subject to the restrictions of laws and the companys charter. Enforcement against the participatory interest has certain specifics which are described below but it is generally possible. Therefore, theoretically the participatory interest corresponds to two major requirements established by Article 576 of the Civil Code of Ukraine: it can be alienated and enforced against.

Ownership of the participatory interest is inseparably connected with corporate rights and obligations. The scope of corporate rights includes not only proprietary (pecuniary) rights (right to participatory interest, right to receive a portion of profit and a portion of the companys property in case of liquidation, etc.), but non-proprietary (organizational) rights as well (rights to participate in the management of the company, to review the documents related to the companys activity, etc.). Taking into account that only material rights can be pledged, it appears to be incorrect to define the subject of pledge generally as corporate rights related to participation in the company.

However, even specifying proprietary corporate rights as collateral may also cause difficulties: these rights arise out of and always follow the participatory interest (rather than the other way around), and, therefore, cannot be alienated separately.

The supporters of indication of the corporate rights as the subject of pledge interpret Article 23 of the On Pledge Act as if the participatory interest may be enforced against by way of its assignment. However, the law refers to the assignment of the right of claim arising out of the pledged right, which raises a lot of questions if applied to corporate rights.

Therefore, upon analysis of existing legislation it appears to be questionable if the corporate rights can be a separate subject of pledge, and that it is more correct and safer to pledge the participatory interest along with the proprietary rights arising out of it rather than the rights themselves.

Pledge agreement, registration of pledge

The agreement on pledge of the participatory interest and property rights arising out of it can be concluded in a simple written form. Notarization is not required, unless the parties decide to have it notarized.

The registration of the pledge is not mandatory. However, it is advisable to register the pledge in the State Register of Encumbrances of Movable Property. According to Paragraph 12 of Article 12 of the On Securing Creditors Claims and Registration of Encumbrances Act of Ukraine, registration of the encumbrance gives it effect and validity in relations with third parties. Otherwise, it will be valid only in relations between the pledgee and the pledgor.

Corporate restrictions

As a rule, pledge of the participatory interest assumes the possibility to transfer the participatory interest to the pledgee or a third party in case of the borrowers default. According to Article 53 of the On Business Companies Act, alienation by the participant of its participatory interest to third parties is allowed, unless otherwise provided for by the charter. Therefore, if the pledgee is not a participant of the company, it has to make sure that the companys charter does not prohibit transfer of the participatory interest to a third party.

In addition, corporate law provides the participants of the company with the right of first refusal in case of the sale of the participatory interest to a third party. Taking into account that there is a risk that the enforcement against the pledged participatory interest may be interpreted as the alienation for compensation and, therefore, considered equal to the sale, we recommend ensuring the compliance of the pledgor with the procedure of exercise of the right of first refusal, as the condition precedent to the extension of credit to the borrower.

Methods of enforcement

As mentioned above, the creditor is interested in being able to enforce the pledge by way of getting the participatory interest into ownership or its sale to third parties. However, it is questionable if such methods of enforcement are generally possible.

Article 57 of the On Business Companies Act and Article 149 of the Civil Code of Ukraine restrict the right of the creditor to enforce against the participatory interest, except in case when the participant lacks other property to satisfy the creditors claims and only by way of enforcement against the portion of property of the company corresponding to the value of the participatory interest, which has to be paid in cash or detached in kind. Enforcement against the whole participatory interest terminates the participation of the participant in the company. Under the conservative interpretation, these provisions may be understood as the prohibition to replace the participant in the course of enforcement of the pledge.

However, the wording of Article 57 of the On Business Companies Act and Article 149 of the Civil Code of Ukraine appears to be not so monosemantic. Until 27 April 2007, Article 57 had the title Enforcement against the participatory interest of the participant in the limited liability company and directly prohibited the practice. Upon adoption of the Civil Code and adaptation of the On Business Companies Act thereto, the norm underwent changes and now regulates enforcement against the portion of property in proportion to the participatory interest of the participant. Absence of direct prohibition allows the argument to be made that the statutory methods of securing fulfilment of obligations may be applied. As a rule, in practice the parties to the pledge agreement guide their relations by the specific norms regulating the pledge rather than by the general ambiguous norm of corporate laws.

According to Paragraph 6 of Article 20 of the On Pledge Act of Ukraine, enforcement of the pledge is done upon a decision of the court or arbitration, notarys writ of execution, unless otherwise provided for by the Act or the pledge agreement. Therefore, the parties to the pledge agreement are entitled to agree on the contractual procedure of enforcement against the pledged participatory interest.

The method of enforcement against the pledged participatory interest should depend on how the legal nature of the participatory interest is determined by the parties. If the subject of pledge is defined as the material rights, it is arguable whether Article 23 of the On Pledge Act allows the assignment of the participatory interest to the pledgee or third parties. As mentioned above, the Act refers to the assignment of a claim arising out of the property rights under the pledge rather than the participatory interest. This may lead to an unfavourable interpretation. It appears that this norm may be applied in the pledge agreement only by analogy, in accordance with the freedom of contract principle.

Should one consider the participatory interest as movable property, the On Pledge and On Securing Creditors Claims and Registration of Encumbrances Acts of Ukraine envisage a general procedure, according to which the sale of the pledged property is performed by a state execution officer (bailiff) through a public action based on the court decision or writ of execution issued by a notary. However, the parties may also establish a contractual procedure of enforcement. In particular, the On Securing Creditors Claims and Registration of Encumbrances Act offers to the pledgee such methods as transfer of the pledged movable property to the pledgee or its sale to a third party (individually or through an auction). At the same time, if the debtor argues against transfer of the pledged property to the pledgee, the latter may get satisfaction from the sale of the subject of pledge or file an action with a court.

Therefore, we have to admit that the procedure of enforcement against the participatory interest and corporate rights is not clearly regulated by existing Ukrainian law, which prevents formation of a unified practice and generates a lot of questions.

Corporate risks

In addition to the above mentioned disputes about the subject of pledge and methods of enforcement, the pledgee may also face other difficulties which arise from Ukrainian corporate law.

Transfer of the participatory interest to the pledgee or a third party requires amendment of the companys charter and registration of such amendments. The charter is amended by the general participants meeting of the company. Usually, it is not problematic if the company has one participant and 100% participatory interest is enforced against. In this case the decision is executed by the new owner. However, if there are other participants, the new owner may require assistance of the pledgor to convene and hold the meeting. To ensure holding of the meeting (and adoption of the respective resolution) the pledgee should control a participatory interest of more than 60%. Otherwise, even the court decision ordering the participants to approve amendments of the charter due to transfer of the participatory interest to the pledgee or a third party may be ineffective, as there are no means to force the participants to hold the meeting and approve a respective resolution.

In practice, the parties often include in the loan and pledge agreements provisions obliging the pledgor to ensure, before the transfer of funds to the borrower, execution of the conditional resolution on amendment of the charter by all participants of the company. Such a resolution is to enter into force upon default of the borrower. However, the risks cannot be fully eliminated, especially in case of a long-term pledge, as such a resolution may be cancelled by the participants, some changes may occur in the company (including change of other participants, change of the share capital amount) and, therefore, the resolution may be rejected by a state registrar.

Furthermore, even if the amendments to the charter are duly adopted, the pledgee may face difficulties registering them. According to Paragraph 5 of Article 8 of the On State Registration of Legal Entities and Individuals Entrepreneurs Act of Ukraine, the constitutive documents of a legal entity and amendments thereto have to be signed by participants or authorized persons, unless another procedure of their approval is established by the law. In practice, most state registrars demand that the charter be signed by all participants of the company or, less frequently, by all participants present at the meeting. It is possible to argue that there exists another procedure of approval established by the Act: approval by the general participants meeting, according to which amendments to the charter are adopted by more than 50% of votes of the participants. However, to prove this and force the state registrar to register the amendments to the charter, the pledgee may need to go to court. Therefore, from the corporate standpoint the safest option is the pledge of the 100% participatory interest, when other participants cannot create obstacles.

Conclusion

Summarising the above mentioned gaps and contradictions of Ukrainian legislation that cause concern for creditors who find themselves needing to enforce a pledge, we have to admit that today the pledge of participatory interest cannot be considered as an effective method of securing performance of obligations.

It appears that without the cooperation of the pledgor and other participants of the company the enforcement procedure may turn to a time and cost consuming court dispute with an unpredictable result. Undoubtedly, both creditors and borrowers are interested in introduction to the law of a clear and simple procedure for pledging the participatory interest and its enforcement. Meanwhile, pledge of the participatory interest may be recommended only as an additional guarantee, supplemental to other means of security.

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