August 14 2009

In January 2009 amendments came into force that significantly changed the law surrounding pledges of movable and immovable assets. This update considers the developments in respect of movable assets, as such pledges are widely used to secure obligations.

At a fundamental level, the amendments have clarified the general concept of foreclosure. Previously, Article 349(2) of the Civil Code allowed for a levy of execution of movable assets without resorting to the courts, except as otherwise specifically stated in the relevant agreement. However, the new law establishes a general rule that a levy of execution is subject to court proceedings unless the law or the relevant agreement provides otherwise, thereby unifying the different rules on the foreclosure of movable and immovable property. In spite of certain changes in the underlying approach of the legislation, a pledgor and pledgee may incorporate into their agreement a condition that allows for non-judicial foreclosure on movable assets, if such a provision is not otherwise prohibited by law.

The amendments have also introduced more ways in which pledged property can be realized. In addition to the pre-existing option of a tender sale, a pledge holder may now dispose of pledged property through a commission agreement, which makes a pledge a more attractive form of security. However, quoted shares must be sold through a stock exchange. Moreover, if both parties are businesspeople or business entities and if the contract was entered into for business purposes, the parties may agree that the pledge holder has the right to (i) acquire ownership of pledged property in lieu of payment by the debtor, or (ii) sell pledged assets to a third person under a commission agreement or otherwise. Consequently, the greatest comfort for pledge holders lies in the effective use and enforcement of a pledge without a court ruling.

However, it is necessary to consider whether Russian law provides for specific rules which (i) allow the pledge holder to sue the pledgor in the event of the latter's breach of obligation, or (ii) prohibit an out-of-court levy of execution. In this context there are at least two circumstances in which a judicial order is required for foreclosure. If an issuer of mortgage-backed securities defaults, a levy of execution on the assets that constitute the mortgage pool is subject to a court ruling. Similarly, the forfeiture of interests in a limited liability company requires a court order. Thus, despite the other progressive changes in the law on pledges, interests in limited liability companies are outside the scope of the new legislation, making them less attractive in terms of realizing a pledge without the involvement of the courts.

In considering how non-judicial pledge enforcement works in other cases, the main problem that a pledge holder will face is that, in practice, most parties are physically and legally unable to use a possessory pledge (ie, a pledge under which the assets are physically transferred to the creditor). It is generally impractical for a pledgee to receive and store pledged property, as this may entail special premises and additional costs, especially for banks that enter into numerous agreements involving a vast number of pledged assets. Moreover, a pledgor is unable to transfer assets if - as is often the case - it pledges the equipment that it uses in its principal activities.

Therefore, the pledge holder typically does not take possession of the pledged assets, which are held and used by the debtor. As a result, attempts to realize the assets - by acquiring ownership of pledged property in place of payment by the debtor or through a sale under a commission agreement or otherwise - will be impeded because the pledge holder does not have the property at its disposal. Pursuant to Article 223(1) of the code, transfer of ownership in respect of movable property is based on the physical transfer of the property itself, unless the law or relevant agreement provides otherwise. Article 29 of the Law on the Securities Market (39-FZ/1996) provides that dematerialized securities are regarded as having been transferred once they are recorded in the accounts of the party that receives them. However, such a transaction can be seen as the formal equivalent of a physical transfer.

Russian law recognizes four types of account that may be opened in the register of security holders: accounts for owners, nominal holders (ie, custodians), asset managers and pledge holders. No securities are transferred to a pledgor's account, which is opened so that an encumbrance (on the basis of the pledge agreement) can be recorded in the register. Thus, the securities remain to be recorded in the pledgee's account and this special accounting procedure does not give the pledgee possession of the pledged property. There are two solutions to this problem.

First, a debtor may voluntarily transfer pledged property to the creditor at the latter's request. However, this rarely happens and cannot be relied upon as a general rule.

Second, the creditor may forfeit the pledged property through enforcement. This is a more attractive solution, as it allows the creditor to take action to the enforce the performance obligation, irrespective of whether the debtor is willing to cooperate.

Enforcement may be carried out through the courts if the pledgee enters a claim that the obligation has not been duly performed and seeks a levy of execution. Alternatively, the pledgee may apply to a notary, who will examine the pledgee's papers and the pledgor's objection. If the notary considers the claim to be incontrovertible, he or she gives the pledge agreement his or her special approval, which makes it a valid basis for commencing enforcement proceedings. Notaries are empowered to (i) evaluate and either uphold or reject arguments from both parties, and (ii) rule on the validity of creditors' claims at their own discretion. However, pledgors can challenge notaries' decisions and file actions to seek a re-evaluation of the parties' arguments and the notary's decision in court.

The new provisions are intended to simplify foreclosure on and disposal of pledged assets without a court ruling - an undoubted benefit for pledge holders. However, the concept of non-judicial foreclosure is under strain, since a pledgor can refuse to transfer pledged property to the creditor. Moreover, the special provisions on notary approval cannot resolve this impasse without the backing of the judgment proceedings that they were designed to avoid. Gaps in the new provisions prevent pledge holders from fully exercising their right to initiate a levy of execution without court proceedings. Therefore, the new provisions must be modified in order to allow pledgees to exercise a simplified and effective foreclosure procedure. However, the legislature's attempt to unify and simplify the provisions relating to foreclosure indicate a trend towards putting the means to resolve a wide range of matters - including issues regarding levy of execution and mutual control during foreclosure proceedings - into the hands of the transaction parties with the aim of making a pledge of movable property a more effective form of security.

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