Share pledge in Ukraine
One of the measures aimed to secure contractual obligations under the Ukrainian law may be share pledge in the authorized capital of Limited Liability Company. LLC is one of the most widespread forms of making business in Ukraine).
If your debtor is owner or co-founder of the Ukrainian LLC, you may conclude pledge agreement on share in the authorized capital of such LLC and, in case of the debtor’s default under the principal agreement, accept the pledged share and join LLC founders.
It is the perfect picture described, although in practice you may face some difficulties. This article highlights procedure for issuing share pledge according to laws of Ukraine, shows efficiency level of such instrument and recommends measures to be taken in order to strengthen the creditor’s position.
Concluding share pledge agreement.
The right on share pledge arises from the moment of concluding share pledge agreement, but if the parties decide to notarize such agreement, it arises from the moment of its notarization. Despite the fact that share pledge agreement may be drafted in simple written form, we recommend our clients, in order to verify identity of signatories and to mitigate risks of recognizing the agreement as invalid, to notarize such agreements.
The parties to share pledge agreement (the pledger and the pledgee) may be both natural persons and legal entities. Both the debtor himself under the principal agreement and third party (property guarantor) may act as the pledger.
Property (including share in LLC authorized capital) can be pledged only by its owner, being entitled to alienate such property, or by the person whereto the owner transferred the relevant rights on property, in the duly prescribed manner.
We pay attention that LLC member is entitled to alienate its share (or a part thereof) in authorized capital only in respect of the paid part (it shall be actually contributed to LLC authorized capital). Therefore, it is recommended, before issuing pledge, to request from the pledger a document certifying payment of share being subject to pledge. It may be cash order, receipt, payment order, act of transfer on LLC balance, LLC accounting statement, etc.
Pledge agreement usually stipulates the following:
- essence, amount and term (date) of fulfillment of the principal obligation secured by pledge, and/or reference to the agreement of principal obligation;
- description of the subject of pledge;
- other terms and conditions agreed by the parties.
For the purposes of pre due diligence, it is recommended to conduct expert assessment of the market value of share in LLC authorized capital, as well as external audit of LLC (the pledger).
It should be noted that there may be two types of the cost of member’s share:
- nominal cost, i.e. monetary expression of share in authorized capital, indicated in the State Register of legal entities and in LLC constituent documents;
- actual cost, i.e. market value, fixed on the basis of market value of the aggregate shares of LLC members, in proportion to the amount of member’s share. Market value isdetermined not just by monetary expression of share, but by the amount of the company’s aggregate assets, with regards to its liabilities (i.e. the company’s assets minus liabilities) in proportion to the amount of pledged share.
Subject of share pledge agreement is the nominal cost of share, while in fact the creditor is concerned in receiving market value fixed at the moment of concluding the agreement, in case of the debtor’s default. Therefore, it is so important to be able to suppress the actions of the debtor aimed at reducing the share actual cost.
Share pledge registration
The Ukrainian law does not provide for the obligation to register share pledge in the State Register of encumbrances. But it is advisable to perform such registration for the following reasons.
The law provides for the option to issue several pledges in respect of the same LLC share. In such case, the creditor (the pledgee) of registered pledge willhave preemptive right to satisfy claims arising from pledged property against the creditors (the pledgees) of unregistered pledges and the creditors (the pledgees) of pledges being registered later.
Share pledge isregistered in the State Register of encumbrances of movable property of Ukraine. Notaries (both public and private ones) can act as registrars. In practice, registration takes place immediately after notarization of the pledge agreement, by the same notary. Upon that the notary issues extract from the State Register, which certifies registration of encumbrance (pledge).
The most difficult aspect of share pledge for the creditor is to receive the pledged share (especially in its original value). The law provides for three ways of foreclosure, in case of non-fulfillment of the debtor’s obligations:
- judicial proceedings (by means of applying claim to court): it can be a longstanding and complicated process;
- extrajudicial proceedings (based on the notary’s executive inscription): meantime, not all notaries agree to make executive inscriptions;
- pretrial settlement (based on agreement concluded between the creditor and the debtor, which prescribes transfer of pledged property into the creditor’s ownership): the most effective way, since it requires only unilateral notification of the debtor, without its engagement in whole process of transfer of pledges property. However, as for share in LLC authorized capital, such method is rather ambiguous.
Creditor’s (pledgee’s) risks and ways to mitigate them
1. Alienation of pledged share by the debtor (the pledger). Unfortunately, unfair debtor may freely alienate pledged share in favour of third party, due to imperfect procedure for changing LLC owner stipulated by the Ukrainian law. The registered pledge will not interfere with this.
Nevertheless, it is advisable to register share pledge in the State Register of encumbrances. As stated above, it will strengthen to some extent the pledger’s position, e.g. in case of selling the share by unfair pledgee.
2. Significant depreciation of pledged share. Market value of share in authorized capital is dynamic: the higher the asset value and the earning capacity, the higher is the cost of share, and vice versa.
Such risk can be mitigated by means of the following: share pledge agreement may include clauses with prohibition to make certain decisions by the pledger regarding LLC; the pledger may appoint its representatives who will join LLC executive or supervisory board; the pledger may conduct periodic audits of LLC, etc.
3. Absence of clear mechanism for pretrial settlement. This problem is related mainly to the procedure for changing LLC member, as set forth in the Law of Ukraine on Limited Liability Companies. As well as to requirements of state registrars engaged in registration process of a new member in the State Register of legal entities.
Effective solution may be prepared depending on concrete case. At the same time two other ways of foreclosure (judicial and extrajudicial) may be used as well.
Summing up, we conclude that such mechanism, as share pledge in LLC authorized capital, is better to be applied in parallel with other securing obligations, namely: bank guarantee, pledge of real estate, etc. Otherwise, it is necessary to develop a detailed and thought-out mechanism of share transfer from the debtor to the creditor without engaging the debtor, in case of the debtor’s default.
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