2.4. Rights and obligations of the parties

to the pledge agreement

Draft articles 343 - 347 deal with the mutual rights and obligation of the pledgor and the pledgee. They include default rules applicable in the absence of contrary agreement of the parties. As a matter of drafting, all similar provisions could be placed in this part of the text. This would greatly enhance the clarity and transparency of the draft provisions.

Draft article 343 provides that the party in possession of the pledged asset bears the obligation to preserve and maintain it. Draft article 344 provides that the pledgor is liable for the accidental loss or damage to the pledged asset, unless otherwise agreed. Draft article 345 deals with substitution of another asset for the pledged asset (e.g., where the pledged asset is used to produce a new product or where the pledged asset is destroyed and the pledgor is responsible). Draft article 346 provides that the pledgor in possession may use the pledged asset and even pledge it, but only with the consent of the pledgee. Draft article 347 provides that, in certain cases, that the pledgee may demand transfer of possession of the pledged asset.

There is no problem with all these provisions, but the Guide contains a separate chapter on the rights and obligations of the parties to the security agreement. The value in the recommendations in this chapter is that: (a) they set out a number of issues that the parties may wish to address in their agreement; (b) in the absence of contrary agreement of the parties, they provide how these issues should be resolved (non-mandatory rules); (c) they deal with a number of issues that are not subject to party autonomy (mandatory law rules).

For example, non-mandatory rules refer to the rights of the secured creditor, when in possession of the encumbered assets, to be reimbursed for reasonable expenses incurred for their preservation and to make reasonable use of them, and, when not in possession, to inspect them <1>.

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<1> Recommendation 113.

Examples of mandatory rules include: (a) the party in possession of the encumbered assets is obliged to take reasonable steps to preserve them and their value; (b) the secured creditor in possession is obliged to return the encumbered assets to the grantor when all commitments to extend credit have been terminated and the security agreement has been extinguished by full payment or otherwise <1>.

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<1> Recommendation 112.

2.5. Enforcement

Draft article 348.1 appropriately deals with the grounds for enforcement of a pledge and provides that the pledgee may initiate enforcement if the secured obligation is not performed or is performed in an unsatisfactory way. It would be clearer though to refer to default and leave it to the parties to set out the events of default in their pledge agreement, with any appropriate rules to deal with situations where there is no agreement by the parties. In addition, draft article 348.2 provides that enforcement may be denied if the breach is insignificant and the amount of the secured obligation is clearly disproportionately lower than the value of the pledged asset. This is in line with good faith and reasonable commercial standards. It is very useful that this draft article explains the meaning of these terms (that is, the outstanding obligation is less than 5% of the value of the pledged asset, the delay is less than three months and systematic breach in the case of installment payments). Finally, draft article 348.4 appropriately provides that the debtor and any third-party pledgor may cure the default at any time before the sale by paying the outstanding amount of the secured obligation plus interests and costs.

Draft article 349.1 appropriately provides that enforcement must take place through a court decision, unless otherwise agreed by the parties, in which case enforcement will take place according to the agreement of the parties. The agreement must be in the same form as the form required for the pledge agreement (that is, simple written form, unless notarial form is required). In addition, draft article 349 sets out several exceptions in which enforcement must be made through court proceedings (e.g., the pledged assets are housing items of a natural person or assets of historical, artistic or cultural value).

Draft article 350.1 provides that enforcement under draft article 349 must take place in accordance with the statute on pledge unless otherwise provided by other statute. The meaning of this provision and, in particular, whether it refers to judicial enforcement only or also to extra-judicial enforcement, is not very clear. If it applies to judicial enforcement only, it is fine. If, however, it applies to both judicial and extra-judicial enforcement, the reference to other law undermines or even contradicts the provision of draft article 349 that extra-judicial enforcement takes place in accordance with the agreement of the parties. Draft article 350.2 has been deleted. Draft article 350.3 and 4 appropriately deal with surpluses and shortfalls left after the sale of the pledged assets and the satisfaction of the secured obligation. Draft article 350.5 seems to repeat the provision of draft article 348.4 providing that the debtor and a third-party pledgor may cure the default and redeem the assets. Draft article 350.6 provides that the pledgee may acquire the asset only if the auction has failed.

Draft article 351 deals with accelerated discharge of the secured obligation in cases where, for example, the pledged asset is removed from the possession of the pledgee in breach of the pledge agreement or where the asset is destroyed. As already mentioned, it would be clearer to refer to default and leave it to the parties to set out in the pledge agreement the events that would constitute default.

Draft article 352 deals with the termination of a pledge, for example, when: (a) the secured obligation ceases to exist; (b) the pledgor violates its duty to keep safe and maintain the pledged assets; (c) the pledged assets are destroyed; (d) when enforcement takes place or is impossible; (e) the pledge agreement ceases to exist and the pledged assets are returned to the pledgor. A reference is made in draft article 352.2 to correction of the registry record but only for mortgages.

Draft article 353.1, instead of dealing with the finality of rights acquired pursuant to enforcement, seems to be dealing with priority between a pledgee and a transferee that acquires the right from the pledgor (not pursuant to enforcement by the pledgee). A transferee of the pledged assets acquires them subject to the pledge, except the pledgee consented to the transfer. Draft article 353.2 speaks of a pledge as if it was a personal obligation and refers to the transferee having the rights and the obligations of the transferor/pledgor.

Draft articles 354 - 358 seem to out of place right after the provisions on enforcement and they deal with miscellaneous issues. Draft article 354 deals with the continuation of the pledge in the proceeds of the pledged assets cases where the pledged assets are confiscated, but this does not seem to be necessary in view of draft article 340. Draft article 355 provides that the pledgee may transfer its rights and obligations under the pledge agreement only together with the secured obligation without the consent of the pledgor but with the consent of the debtor (there seems to be a different rule allowing the transfer of the mortgage without the obligation secured by a mortgage). Draft article 356 provides that the pledge ceases to exist if the pledgee assigns the secured obligation without the consent of the pledgor. Draft article 357 deals with pledge of inventory. Accordingly, the new inventory takes the place of sold inventory (presumably, the pledge extends also to the proceeds of the sold inventory); a reduction in the value of the new inventory is allowed as long as it is equal to the amount of the secured obligation paid; the pledgor has to maintain a book of pledges; the pledgee may stop the sales of inventory if the pledgor violates the terms of the pledge agreement. Draft article 358 deals with pledge of assets in a pawnshop. A set of provisions that were included in a previous draft and dealt with pledges of receivables, bank accounts, intellectual property, corporate rights and securities do not seem to have been approved.

The Guide contains elaborate provisions on enforcement. First, it sets out a general standard of conduct that every secured creditor must comply with when enforcing its security right (good faith and commercially reasonable manner) <1>. Then, the Guide describes the limits of party autonomy in the context of enforcement. The general standard of conduct may not be waived unilaterally or varied by agreement at any time <2>. Other enforcementrelated rights and obligations may generally waived unilaterally or varied by agreement, but only after default to avoid pressure being exercised on the borrower to waive its rights in order to be given credit <3>.

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<1> Recommendation 131.

<2> Recommendation 132.

<3> Recommendations 133 - 135.

To make the law more transparent, the Guide includes both recommendations that summarize in one recommendation all the post default rights of the grantor and the secured creditor and several recommendations that deal with each such right in detail. Generally, the grantor may pay in full the secured obligation and obtain a release, apply to a court or other for relief, propose to the secured creditor or reject the secured creditor's proposal to acquire the encumbered assets in satisfaction of the secured obligation and exercise any other right provided in the security agreement or any law <1>. The secured creditor may obtain possession of a tangible encumbered asset, sell or otherwise dispose of, lease or license an encumbered asset, propose that the secured creditor acquire an encumbered asset in total or partial satisfaction of the secured obligation, enforce its security right in an attachment, collect on or otherwise enforce a security right in an encumbered asset that is a receivable, negotiable instrument, right to payment of funds credited to a bank account or right to receive the proceeds under an independent undertaking, and exercise any other right provided in the security agreement (except to the extent inconsistent with the provisions of this law) or any law <2>.

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<1> Recommendation 139.

<2> Recommendation 141.

In addition, the Guide provides for judicial and extra-judicial enforcement. Judicial enforcement is generally left to the civil procedure code of the enacting State. Extra-judicial enforcement is regulated in detail. It is neither a panacea as judicial enforcement may be equally reliable and expeditious, nor a threat as it is strictly regulated and the pledgor may always refer the matter to the courts. For example, for the secured creditor to obtain possession of an encumbered asset out of court, the grantor must have consented in the security agreement to the secured creditor obtaining possession without applying to a court or other authority, the secured creditor must have given the grantor and any person in possession of the encumbered asset notice of default and of the secured creditor's intent to obtain possession without applying to a court or other authority, and, at the time the secured creditor seeks to obtain possession of the encumbered asset the grantor and any person in possession of the encumbered asset must not object <1>. The Guide includes also a number of recommendations setting out how notice of extra-judicial enforcement is to be given and to whom <2>. This is the way in which the Guide ensures protection of the interests of the grantor and other third parties with rights in the assets in the case of extra-judicial enforcement.

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<1> Recommendation 147.

<2> Recommendations 149 - 151.

Most importantly, the Guide deals in some detail with the distribution of the proceeds of the disposition of the encumbered assets and finality of rights acquired in the encumbered assets by persons that acquired the assets after out-of-court enforcement of a security right (civil procedure law should settle these matters in the case of judicial enforcement) <1>. Generally speaking, the enforcing secured creditor must apply the net proceeds of enforcement to the secured obligation. Any surplus has to be turned over to any subordinate competing claimant that announced its claim and any balance remaining to the grantor. The secured creditor has a personal claim for any shortfall. The transferee of an encumbered asset acquired in the context of enforcement acquires it in principle free of the security right of the enforcing secured creditor and any subordinate secured creditor, but subject to any security right with priority over the interest of the enforcing secured creditor <2>.

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<1> Recommendation 152 - 155.

<2> Recommendation 161.

The Guide also contains a set of detailed recommendations on the enforcement of a security right in receivables, negotiable instruments and documents, rights to payment of funds credited to a bank account, and rights to receive the proceeds under an independent undertaking <1>. The Supplement also discusses in some detail the enforcement of a security right in intellectual property, without adding any intellectual property specific recommendation to the general recommendations on enforcement <2>.

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<1> Recommendations 167 - 177.

<2> Supplement, paras. 229 - 253.