Loans secured by cash flows and goods are one of the primary methods of financing for companies engaged in import and production of goods, wholesale and retail trade, since it is precisely cash flows and goods that constitute the main part of their assets.
Such loans are attracted not only to finance the commodity cycle but also for the acquisition of property, debt restructuring, and generally to provide the company with working capital.
This type of financing is associated with higher risk compared to other types of commercial lending because the source of loan repayment is the proceeds from the sale of goods.
Furthermore, the collateral for such loans consists of property that is constantly changing and whose value can decrease rapidly. Goods are much less liquid than cash flows: their production requires completion, and they must be sold and paid for.
Servicing such loans requires intensive monitoring by the lender over the condition and movement of the collateral. Notably, when the lender and the borrower cannot ensure control over the pledged property (goods) under a pledge of revolving goods, some countries widely use the field warehousing system. In this case, the pledged goods are transferred into the possession of a third party (the field warehouse), which releases the goods to the pledgor only upon the instruction of the lender. The pledge of goods is formalized by pledging warehouse receipts issued by the field warehouse. Nevertheless, goods are a valuable asset whose value can cover the loan and the bank's associated expenses. Risks associated with this asset can be reduced through constant ongoing monitoring of the goods and the cash flows from their sale. In this regard, the lender often requires the simultaneous pledge of both the goods and the rights of claim under contracts for their sale.
Thus, according to estimates by the International Finance Corporation, the value of pledged goods taken into account when issuing loans is up to 50% in OECD countries and has no value in developing market countries. This statistic indicates that the value of property as collateral is determined not only by its physical and economic parameters but also by the legal regulation of pledge and its practice.
To enable the use of a pledge of revolving goods, i.e., goods sold and reacquired by the pledgor, it is necessary for the law to recognize the possibility of:
Consequently, the pledge of "revolving" property was not used for a long time in states whose legislation required, as a condition for its validity, the transfer of the pledged property to the pledgee and/or precise identification of the pledged property (in some states, these requirements still apply).
Currently, these requirements are not imposed for the formalization of pledge in many states. The pledge of "revolving" property is used quite widely there because the law allows its establishment with the following characteristics:
Many legal systems have enshrined these possibilities during the reform of their pledge legislation, particularly drawing on the practice of the floating charge under English law. For example, in the Netherlands, goods can be pledged without transferring possession to the pledgee only if the pledge agreement is notarized or registered with the Inspectorate for Registration and Succession (Inspectie van registratie en successie) of the Dutch Tax Authority. In Greece, a pledge agreement can define its subject as a group of movable property or rights, and the pledge agreement must be registered in a public register (enechyrofylakio). In Hungary, to establish a pledge over the property of a legal entity (in whole or in part) without specifying individual objects, claims, and other rights constituting the property of the legal entity (a floating charge), the pledge agreement must be concluded in writing, notarized, and registered with the Hungarian State Chamber of Notaries.
The main feature of a floating charge is the right of the pledgor, in the ordinary course of its business, to freely dispose of the pledged property (until the moment of crystallization), which is acquired by a new owner free of any encumbrance. Crystallization of the pledge means that upon the occurrence of certain circumstances, the floating charge becomes a fixed charge (a charge without the right of the pledgor to dispose of its subject) concerning the property that is its subject and is in the possession of the pledgor at the moment of crystallization.
In Russia, the pledge of property which the pledgor has the right to freely dispose of within certain limits is regulated by the provisions on the pledge of revolving goods (Article 357 of the Civil Code of the Russian Federation, Chapter 3, Section II of the Law on Pledge).
Although these provisions allow for the description of property by generic characteristics and the disposal of the pledged property, the use of the pledge of revolving goods is not effective due to the rather conservative interpretation by Russian courts of the rules on the pledge of revolving goods and the lack in practice of a necessary system for monitoring the pledged property, the presence of which is critical for a pledge of revolving goods. Established Russian judicial practice allows describing pledged property by generic characteristics only in the case of a pledge of revolving goods (items) (clause 2 of the Information Letter of the Presidium of the Supreme Arbitrazh Court of the Russian Federation No. 26 of January 15, 1998).
For example, the Federal Arbitrazh Court of the Moscow District, in its Ruling of December 9, 2002, in case No. KG-A40/7892-02, indicated that "it is precisely the pledge agreement that must specify the individual characteristics of the subject of the pledge, excluding the possibility of its subsequent replacement with similar property and the emergence of disputes between the pledgor and the pledgee regarding the property that was the subject of the pledge in each specific case, based solely on the generic or type characteristics of this property, which is permissible only for a pledge of revolving goods."
The Federal Arbitrazh Court of the Central District, in its Ruling of February 21, 2008, No. F10-238/08 in case No. A23-979/07G6-119, stated regarding a pledge of claims agreement that "based on the essence of the pledge obligation, when defining the subject of the pledge in the agreement, not only the type of property must be named, but individual characteristics of the subject of the pledge allowing it to be distinguished from homogeneous items must also be indicated."
Conclusion of a Pledge Agreement for Revolving Goods
Identification of the Subject of the Pledge when Concluding the Pledge Agreement
The specificity of the pledge of revolving goods lies in its subject – property whose existence, properties, and characteristics are constantly or periodically changing. Due to this specificity, the formal requirements for the content of a pledge agreement for revolving goods differ from the general requirements regarding the description of the subject of the pledge.
In a pledge of revolving goods, indicating individualizing characteristics of the pledged property in the pledge agreement is not mandatory because the existence and/or properties of the goods are constantly changing. It is sufficient to indicate the generic characteristics of the pledged property (e.g., the name of the product). This position prevails in the judicial practice of arbitrazh courts.
The Condition of the Pledge Agreement on the Location of the Subject of the Pledge
According to the Law on Pledge, a pledge agreement for revolving goods must contain a condition on the location where the pledged revolving goods are stored. This requirement, as a criterion for resolving the issue of the conclusiveness of the pledge agreement, is outdated and does not correspond to international standards of pledge regulation.
Nevertheless, the storage location of pledged revolving goods plays a significant role in the organization of control over them by the pledgee. For example, the subject of the pledge can be segregated from the rest of the pledgor's property in one location. Such physical segregation may be accompanied by the placement of signs on the premises where the goods are stored, indicating that the property contained therein is pledged in favor of a specific person. Segregation of the pledged property in a specific location simplifies the control process, as the controlled property and documents are concentrated in one place.
Such "notification" of the pledge can also warn a bona fide potential subsequent lender-pledgee, conducting due diligence on the property offered as collateral, from concluding a pledge agreement for property that is already pledged (and whose pledge agreement prohibits the establishment of a subsequent pledge). However, when deciding on the validity of a subsequent pledge, the awareness of the "subsequent" pledgee is irrelevant (what matters is the existence of a pledge agreement and a prohibition therein on transferring the property into a subsequent pledge). For example, the federal arbitrazh courts of the Volgo-Vyatka and Far Eastern districts recognized a subsequent pledge of revolving goods as invalid on the grounds that the original pledge agreement for revolving goods contained a prohibition on a subsequent pledge without the consent of the original pledgee. Furthermore, the Federal Arbitrazh Court of the Far Eastern District concluded that the subsequent pledge agreement is invalid to the extent equal in value to the original pledge agreement for revolving goods, and to the extent exceeding the value of the original pledge agreement for revolving goods, the court recognized the subsequent pledge agreement for revolving goods as invalid on the grounds that such property was absent at the time of concluding the subsequent pledge agreement for revolving goods.
It is necessary to note that if revolving goods are transferred into a subsequent pledge, there is a high risk of disputes arising regarding which property is pledged and in favor of which pledgee. This risk can be reduced if possession of the pledged revolving goods is transferred to a third party (e.g., a warehouse operator). The warehouse operator can issue warehouse receipts, which are transferred to the bank as pledge. In this case, it is not necessary to define the pledged goods by generic characteristics, as the warehouse operator issues the warehouse receipt by specifying the goods that were transferred to it for storage. Goods released from the pledge are excluded from the warehouse receipt.
Verification of the Subject of the Pledge when Concluding the Pledge Agreement
The subject of a pledge of revolving goods often consists of items acquired by the pledgor from third parties. In this regard, when concluding a pledge agreement, the pledgee should be aware of the following risks:
Goods in Turnover May Be Pledged in Favor of the Seller
Property acquired by the pledgor and "replacing" the composition of the subject of the pledge may turn out to be pledged to the seller. According to clause 5 of Article 488 of the Civil Code of the Russian Federation, unless otherwise provided by the sales contract, from the moment the goods are transferred to the buyer until payment, goods sold on credit are deemed to be pledged to the seller to secure the buyer's obligation to pay for the goods. Goods are considered sold on credit if the sales contract provides for payment of the goods a certain time after its transfer to the buyer (clause 1 of Article 488 of the Civil Code of the Russian Federation).
Establishing a pledge on goods that are already pledged leads to the emergence of a subsequent pledge, which significantly reduces the value of the pledge right, since claims under the subsequent pledge are satisfied only after the satisfaction of claims under the prior pledge.
The Pledgor May Not Acquire Ownership of the Property Transferred as Pledge
The pledgor may not acquire ownership of the property acquired by it and intended to "replace" the composition of the subject of the pledge by the time the pledgee seeks recovery against it.
Thus, a sales contract may stipulate that the title to the goods transferred to the buyer remains with the seller until payment is made or other circumstances occur, and in case of non-payment of the goods (non-occurrence of the circumstances provided for in the contract), the seller has the right to demand that the buyer return the goods (Article 491 of the Civil Code of the Russian Federation).
Verification of Title Documents and Pledgor's Representations
In this connection, to verify the absence of third-party rights to the property being pledged, the creditor can analyze:
At the same time, pledge agreements often contain a representation by the pledgor that the property constituting the subject of the relevant agreement is not pledged (and not otherwise encumbered) in favor of third parties. In case of violation of this representation, the pledgee is granted the right to demand early performance of the principal obligation and compensation for losses incurred due to such violation. Furthermore, in case of violation of such a representation, the manager of the borrower-pledgor may be subject to criminal liability for illegal receipt of a loan (Part 1 of Article 176 of the Criminal Code of the Russian Federation), i.e., obtaining a loan by providing the bank with knowingly false information about the economic situation or financial condition of the organization (including inaccurate data on the rights to the property provided as collateral). A condition for criminal liability under this article is the causation of major damage (in the amount exceeding 1,500,000 rubles). It is necessary to note that the legislation of some states provides for a specific criminal offense entailing criminal liability for providing the subject of the pledge into a subsequent pledge without the consent of the original pledgee (see, for example, Article 216 of the Criminal Code of Latvia).
Control over Pledged Revolving Goods
Control over pledged revolving goods is critically important for the effectiveness of their pledge because:
Control over the pledged property can be exercised by the pledgee itself or by a person engaged by it (a collateral monitoring company).
Measures of Control over Pledged Goods
To ensure control over the pledged goods, the following obligations may be imposed on the pledgor:
It is necessary to note that reports on the status of the subject of the pledge are analogous in their purpose to the pledge record book. The pledge record book itself is usually not maintained by pledgors in practice with the composition of information provided for it by clause 3 of Article 357 of the Civil Code of the Russian Federation. In general, the pledge record book can be replaced by other instruments depending on its functions:
If control over the pledged goods is ensured by the pledgor itself, the latter can at any time cease to perform its obligations to ensure control (e.g., revoke the power of attorney issued to the collateral controller; cancel the order on the procedure for issuing goods from the warehouse, etc.). The collateral controller must immediately notify the pledgee of such circumstances; therefore, control over pledged revolving goods can be transferred to a company professionally engaged in such activities.
Collateral Monitoring Company
Many large banks have their own internal departments for servicing loans secured by specific assets, which, among other things, exercise control over the pledged property. Typically, such control is limited: the lender receives financial statements and a list of items pledged from the pledgor on a monthly basis.
In many countries, control over pledged property is carried out on a specialized basis as a separate line of business. This is done by companies (collateral management companies) engaged in storage (transportation) of goods, particularly warehouse operators (e.g., CWT Commodities Pte Ltd.). Some international terminal warehouse operators offer services for managing and controlling pledged property as a separate type of their activity to make their service package for client banks more comprehensive. Some companies are engaged in monitoring pledged property as their main activity (for example, Audit Control & Expertise – ACE).
Services for controlling pledged property involve physical control over it, up to the release of goods to the pledgor only under certain circumstances. Control is also exercised over the turnover of goods, the existence of special conditions for their supply, facts of transfer for storage to a third party, and the existence of rights competing with those of the pledgee.
If the pledgor is unwilling to provide the creditor with information analyzed by the collateral monitoring company, this company can conclude a confidentiality agreement with the pledgor and continue to control the pledged property. In doing so, it will communicate to the pledgee not all information provided by the pledgor, but only information about the occurrence of circumstances that may lead to a decrease or loss of the pledged property.
In general, the degree of control over pledged goods can vary. The highest level of control is achieved when the pledged property is stored on the premises of the collateral monitoring company. These premises can be leased from the pledgor to avoid the costs of moving the goods from their actual storage location.
In Russia, the sphere of services for controlling pledged property is underdeveloped. This is explained, in particular, by the unwillingness of banks-pledgees to provide confidential information to third parties. Therefore, control over pledged revolving goods is usually exercised by the banks-pledgees themselves. In practice, such control is often limited to a formal check of the pledgor's documents, which does not ensure effective control over the existence and condition of the pledged property.
Enforcement against Pledged Revolving Goods
When enforcing against pledged revolving goods, creditors need to secure documents confirming the existence and composition of the pledged property. This necessity arises because in many cases, when considering the pledgee's claim for enforcement against pledged revolving goods, Russian arbitrazh courts deem it necessary to examine the issue of the actual existence of the property against which recovery is sought (revolving goods).
Thus, there is judicial practice where courts have remanded cases for new consideration concerning enforcement against pledged property with the requirement to examine the issue of the actual existence of the pledged property, and where courts have refused to satisfy the pledgee's claim to enforce against the subject of the pledge on the grounds that the property specified in the annex to the pledge agreement was not in the possession of the pledgor at the time of the dispute.
In some cases, the court required the plaintiff (the creditor enforcing against the pledged property) to submit documents confirming the acquisition by the pledgor of property encumbered with a pledge, replacing the pledged property alienated by the pledgor (in particular, acts of inspection of the subject of the pledge, the pledge record book).
Changes in the Regulation of the Pledge of Revolving Goods
In conclusion, it should be noted that the current pledge legislation and the practice of its application are not sufficiently flexible, which affects the use of "dynamic" pledge (a pledge where the subject of the pledge is not fixed by individualizing characteristics but represents changing property or can be fixed at the moment of enforcement), under which revolving goods (and other property whose composition may change) can be pledged.
It appears that with changes in pledge legislation and its judicial application practice (particularly on issues of the content of the pledge agreement, enforcement against the subject of the pledge), companies with "revolving" property in their assets will be able to extract more value from it as property provided as collateral when attracting loans, as it will be valued by creditors at a much higher amount due to the reduced risk of loss of the subject of the pledge.
Such loans are attracted not only to finance the commodity cycle but also for the acquisition of property, debt restructuring, and generally to provide the company with working capital.
This type of financing is associated with higher risk compared to other types of commercial lending because the source of loan repayment is the proceeds from the sale of goods.
Furthermore, the collateral for such loans consists of property that is constantly changing and whose value can decrease rapidly. Goods are much less liquid than cash flows: their production requires completion, and they must be sold and paid for.
Servicing such loans requires intensive monitoring by the lender over the condition and movement of the collateral. Notably, when the lender and the borrower cannot ensure control over the pledged property (goods) under a pledge of revolving goods, some countries widely use the field warehousing system. In this case, the pledged goods are transferred into the possession of a third party (the field warehouse), which releases the goods to the pledgor only upon the instruction of the lender. The pledge of goods is formalized by pledging warehouse receipts issued by the field warehouse. Nevertheless, goods are a valuable asset whose value can cover the loan and the bank's associated expenses. Risks associated with this asset can be reduced through constant ongoing monitoring of the goods and the cash flows from their sale. In this regard, the lender often requires the simultaneous pledge of both the goods and the rights of claim under contracts for their sale.
Thus, according to estimates by the International Finance Corporation, the value of pledged goods taken into account when issuing loans is up to 50% in OECD countries and has no value in developing market countries. This statistic indicates that the value of property as collateral is determined not only by its physical and economic parameters but also by the legal regulation of pledge and its practice.
To enable the use of a pledge of revolving goods, i.e., goods sold and reacquired by the pledgor, it is necessary for the law to recognize the possibility of:
- Describing the pledged property in the pledge agreement by generic characteristics (and not only by specific ones);
- Leaving the pledged property with the pledgor;
- The pledgor disposing of the pledged property (within the limits agreed upon in the pledge agreement).
Consequently, the pledge of "revolving" property was not used for a long time in states whose legislation required, as a condition for its validity, the transfer of the pledged property to the pledgee and/or precise identification of the pledged property (in some states, these requirements still apply).
Currently, these requirements are not imposed for the formalization of pledge in many states. The pledge of "revolving" property is used quite widely there because the law allows its establishment with the following characteristics:
- The subject of the pledge can be described in the pledge agreement by generic characteristics;
- The pledged property can be left with the pledgor;
- The pledgor has the right to use the pledged property to conduct its business activities, including the right to dispose of it.
Many legal systems have enshrined these possibilities during the reform of their pledge legislation, particularly drawing on the practice of the floating charge under English law. For example, in the Netherlands, goods can be pledged without transferring possession to the pledgee only if the pledge agreement is notarized or registered with the Inspectorate for Registration and Succession (Inspectie van registratie en successie) of the Dutch Tax Authority. In Greece, a pledge agreement can define its subject as a group of movable property or rights, and the pledge agreement must be registered in a public register (enechyrofylakio). In Hungary, to establish a pledge over the property of a legal entity (in whole or in part) without specifying individual objects, claims, and other rights constituting the property of the legal entity (a floating charge), the pledge agreement must be concluded in writing, notarized, and registered with the Hungarian State Chamber of Notaries.
The main feature of a floating charge is the right of the pledgor, in the ordinary course of its business, to freely dispose of the pledged property (until the moment of crystallization), which is acquired by a new owner free of any encumbrance. Crystallization of the pledge means that upon the occurrence of certain circumstances, the floating charge becomes a fixed charge (a charge without the right of the pledgor to dispose of its subject) concerning the property that is its subject and is in the possession of the pledgor at the moment of crystallization.
In Russia, the pledge of property which the pledgor has the right to freely dispose of within certain limits is regulated by the provisions on the pledge of revolving goods (Article 357 of the Civil Code of the Russian Federation, Chapter 3, Section II of the Law on Pledge).
Although these provisions allow for the description of property by generic characteristics and the disposal of the pledged property, the use of the pledge of revolving goods is not effective due to the rather conservative interpretation by Russian courts of the rules on the pledge of revolving goods and the lack in practice of a necessary system for monitoring the pledged property, the presence of which is critical for a pledge of revolving goods. Established Russian judicial practice allows describing pledged property by generic characteristics only in the case of a pledge of revolving goods (items) (clause 2 of the Information Letter of the Presidium of the Supreme Arbitrazh Court of the Russian Federation No. 26 of January 15, 1998).
For example, the Federal Arbitrazh Court of the Moscow District, in its Ruling of December 9, 2002, in case No. KG-A40/7892-02, indicated that "it is precisely the pledge agreement that must specify the individual characteristics of the subject of the pledge, excluding the possibility of its subsequent replacement with similar property and the emergence of disputes between the pledgor and the pledgee regarding the property that was the subject of the pledge in each specific case, based solely on the generic or type characteristics of this property, which is permissible only for a pledge of revolving goods."
The Federal Arbitrazh Court of the Central District, in its Ruling of February 21, 2008, No. F10-238/08 in case No. A23-979/07G6-119, stated regarding a pledge of claims agreement that "based on the essence of the pledge obligation, when defining the subject of the pledge in the agreement, not only the type of property must be named, but individual characteristics of the subject of the pledge allowing it to be distinguished from homogeneous items must also be indicated."
Conclusion of a Pledge Agreement for Revolving Goods
Identification of the Subject of the Pledge when Concluding the Pledge Agreement
The specificity of the pledge of revolving goods lies in its subject – property whose existence, properties, and characteristics are constantly or periodically changing. Due to this specificity, the formal requirements for the content of a pledge agreement for revolving goods differ from the general requirements regarding the description of the subject of the pledge.
In a pledge of revolving goods, indicating individualizing characteristics of the pledged property in the pledge agreement is not mandatory because the existence and/or properties of the goods are constantly changing. It is sufficient to indicate the generic characteristics of the pledged property (e.g., the name of the product). This position prevails in the judicial practice of arbitrazh courts.
The Condition of the Pledge Agreement on the Location of the Subject of the Pledge
According to the Law on Pledge, a pledge agreement for revolving goods must contain a condition on the location where the pledged revolving goods are stored. This requirement, as a criterion for resolving the issue of the conclusiveness of the pledge agreement, is outdated and does not correspond to international standards of pledge regulation.
Nevertheless, the storage location of pledged revolving goods plays a significant role in the organization of control over them by the pledgee. For example, the subject of the pledge can be segregated from the rest of the pledgor's property in one location. Such physical segregation may be accompanied by the placement of signs on the premises where the goods are stored, indicating that the property contained therein is pledged in favor of a specific person. Segregation of the pledged property in a specific location simplifies the control process, as the controlled property and documents are concentrated in one place.
Such "notification" of the pledge can also warn a bona fide potential subsequent lender-pledgee, conducting due diligence on the property offered as collateral, from concluding a pledge agreement for property that is already pledged (and whose pledge agreement prohibits the establishment of a subsequent pledge). However, when deciding on the validity of a subsequent pledge, the awareness of the "subsequent" pledgee is irrelevant (what matters is the existence of a pledge agreement and a prohibition therein on transferring the property into a subsequent pledge). For example, the federal arbitrazh courts of the Volgo-Vyatka and Far Eastern districts recognized a subsequent pledge of revolving goods as invalid on the grounds that the original pledge agreement for revolving goods contained a prohibition on a subsequent pledge without the consent of the original pledgee. Furthermore, the Federal Arbitrazh Court of the Far Eastern District concluded that the subsequent pledge agreement is invalid to the extent equal in value to the original pledge agreement for revolving goods, and to the extent exceeding the value of the original pledge agreement for revolving goods, the court recognized the subsequent pledge agreement for revolving goods as invalid on the grounds that such property was absent at the time of concluding the subsequent pledge agreement for revolving goods.
It is necessary to note that if revolving goods are transferred into a subsequent pledge, there is a high risk of disputes arising regarding which property is pledged and in favor of which pledgee. This risk can be reduced if possession of the pledged revolving goods is transferred to a third party (e.g., a warehouse operator). The warehouse operator can issue warehouse receipts, which are transferred to the bank as pledge. In this case, it is not necessary to define the pledged goods by generic characteristics, as the warehouse operator issues the warehouse receipt by specifying the goods that were transferred to it for storage. Goods released from the pledge are excluded from the warehouse receipt.
Verification of the Subject of the Pledge when Concluding the Pledge Agreement
The subject of a pledge of revolving goods often consists of items acquired by the pledgor from third parties. In this regard, when concluding a pledge agreement, the pledgee should be aware of the following risks:
- The acquired goods may be pledged in favor of the seller;
- The pledgor may not acquire ownership rights to the acquired items.
Goods in Turnover May Be Pledged in Favor of the Seller
Property acquired by the pledgor and "replacing" the composition of the subject of the pledge may turn out to be pledged to the seller. According to clause 5 of Article 488 of the Civil Code of the Russian Federation, unless otherwise provided by the sales contract, from the moment the goods are transferred to the buyer until payment, goods sold on credit are deemed to be pledged to the seller to secure the buyer's obligation to pay for the goods. Goods are considered sold on credit if the sales contract provides for payment of the goods a certain time after its transfer to the buyer (clause 1 of Article 488 of the Civil Code of the Russian Federation).
Establishing a pledge on goods that are already pledged leads to the emergence of a subsequent pledge, which significantly reduces the value of the pledge right, since claims under the subsequent pledge are satisfied only after the satisfaction of claims under the prior pledge.
The Pledgor May Not Acquire Ownership of the Property Transferred as Pledge
The pledgor may not acquire ownership of the property acquired by it and intended to "replace" the composition of the subject of the pledge by the time the pledgee seeks recovery against it.
Thus, a sales contract may stipulate that the title to the goods transferred to the buyer remains with the seller until payment is made or other circumstances occur, and in case of non-payment of the goods (non-occurrence of the circumstances provided for in the contract), the seller has the right to demand that the buyer return the goods (Article 491 of the Civil Code of the Russian Federation).
Verification of Title Documents and Pledgor's Representations
In this connection, to verify the absence of third-party rights to the property being pledged, the creditor can analyze:
- The contracts on the basis of which such property is supplied to the pledgor (in particular, for the presence of conditions on commercial credit and pledge in favor of the seller);
- Other documents formalizing the transfer of property into the ownership of the pledgor (typically, acts of acceptance-transfer of property).
At the same time, pledge agreements often contain a representation by the pledgor that the property constituting the subject of the relevant agreement is not pledged (and not otherwise encumbered) in favor of third parties. In case of violation of this representation, the pledgee is granted the right to demand early performance of the principal obligation and compensation for losses incurred due to such violation. Furthermore, in case of violation of such a representation, the manager of the borrower-pledgor may be subject to criminal liability for illegal receipt of a loan (Part 1 of Article 176 of the Criminal Code of the Russian Federation), i.e., obtaining a loan by providing the bank with knowingly false information about the economic situation or financial condition of the organization (including inaccurate data on the rights to the property provided as collateral). A condition for criminal liability under this article is the causation of major damage (in the amount exceeding 1,500,000 rubles). It is necessary to note that the legislation of some states provides for a specific criminal offense entailing criminal liability for providing the subject of the pledge into a subsequent pledge without the consent of the original pledgee (see, for example, Article 216 of the Criminal Code of Latvia).
Control over Pledged Revolving Goods
Control over pledged revolving goods is critically important for the effectiveness of their pledge because:
- Their composition constantly changes;
- Their supply to the pledgor may cease (either due to the fault of the pledgor or due to the fault of its counterparties);
- The value of the goods may significantly decrease;
- Goods acquired by the pledgor into the pledged property must meet certain requirements (regarding quality and value) to ensure their quick sale upon enforcement.
Control over the pledged property can be exercised by the pledgee itself or by a person engaged by it (a collateral monitoring company).
Measures of Control over Pledged Goods
To ensure control over the pledged goods, the following obligations may be imposed on the pledgor:
- To grant the pledgee the right of physical access to the pledged property (including to verify whether goods replacing those that have left the pledge are being received by the pledgor with the necessary frequency), the right to inspect documents related to the subject of the pledge (the right to visit the storage location of the goods, inspect the goods, review documents (obtain copies thereof) necessary to verify the existence, actual condition, and value of the pledged property);
- To provide the pledgee with reports on the status of the subject of the pledge (in particular, property disposed of and received, dates of its disposal and receipt). For objectivity, reports on the status of the subject of the pledge may be prepared by a third party (a collateral monitoring company).
It is necessary to note that reports on the status of the subject of the pledge are analogous in their purpose to the pledge record book. The pledge record book itself is usually not maintained by pledgors in practice with the composition of information provided for it by clause 3 of Article 357 of the Civil Code of the Russian Federation. In general, the pledge record book can be replaced by other instruments depending on its functions:
- Reports of the pledgor, agreed upon by the parties in the pledge agreement (function – providing the pledgee with a document allowing it to monitor the movement of the subject of the pledge and enforce against it);
- A unified register of information on the pledge of movable property (function – providing third parties with information about which property of a person is pledged);
- To grant the pledgee, represented by a collateral controller, exclusive authority to release goods from the warehouse. In this case, goods can be issued to the pledgor only upon compliance with certain conditions, for example, the debtor's payment of the next mandatory payment to the creditor (pledgee) under the secured obligation;
- To transfer to the collateral controller documents related to the pledged property, primarily those necessary for the realization of the pledged property (e.g., certificates of conformity), which, like the goods themselves, may be transferred to the pledgor for sale together with the goods only upon compliance with certain conditions established in the pledge agreement (or in the agreement on the procedure for exercising control over the subject of the pledge).
If control over the pledged goods is ensured by the pledgor itself, the latter can at any time cease to perform its obligations to ensure control (e.g., revoke the power of attorney issued to the collateral controller; cancel the order on the procedure for issuing goods from the warehouse, etc.). The collateral controller must immediately notify the pledgee of such circumstances; therefore, control over pledged revolving goods can be transferred to a company professionally engaged in such activities.
Collateral Monitoring Company
Many large banks have their own internal departments for servicing loans secured by specific assets, which, among other things, exercise control over the pledged property. Typically, such control is limited: the lender receives financial statements and a list of items pledged from the pledgor on a monthly basis.
In many countries, control over pledged property is carried out on a specialized basis as a separate line of business. This is done by companies (collateral management companies) engaged in storage (transportation) of goods, particularly warehouse operators (e.g., CWT Commodities Pte Ltd.). Some international terminal warehouse operators offer services for managing and controlling pledged property as a separate type of their activity to make their service package for client banks more comprehensive. Some companies are engaged in monitoring pledged property as their main activity (for example, Audit Control & Expertise – ACE).
Services for controlling pledged property involve physical control over it, up to the release of goods to the pledgor only under certain circumstances. Control is also exercised over the turnover of goods, the existence of special conditions for their supply, facts of transfer for storage to a third party, and the existence of rights competing with those of the pledgee.
If the pledgor is unwilling to provide the creditor with information analyzed by the collateral monitoring company, this company can conclude a confidentiality agreement with the pledgor and continue to control the pledged property. In doing so, it will communicate to the pledgee not all information provided by the pledgor, but only information about the occurrence of circumstances that may lead to a decrease or loss of the pledged property.
In general, the degree of control over pledged goods can vary. The highest level of control is achieved when the pledged property is stored on the premises of the collateral monitoring company. These premises can be leased from the pledgor to avoid the costs of moving the goods from their actual storage location.
In Russia, the sphere of services for controlling pledged property is underdeveloped. This is explained, in particular, by the unwillingness of banks-pledgees to provide confidential information to third parties. Therefore, control over pledged revolving goods is usually exercised by the banks-pledgees themselves. In practice, such control is often limited to a formal check of the pledgor's documents, which does not ensure effective control over the existence and condition of the pledged property.
Enforcement against Pledged Revolving Goods
When enforcing against pledged revolving goods, creditors need to secure documents confirming the existence and composition of the pledged property. This necessity arises because in many cases, when considering the pledgee's claim for enforcement against pledged revolving goods, Russian arbitrazh courts deem it necessary to examine the issue of the actual existence of the property against which recovery is sought (revolving goods).
Thus, there is judicial practice where courts have remanded cases for new consideration concerning enforcement against pledged property with the requirement to examine the issue of the actual existence of the pledged property, and where courts have refused to satisfy the pledgee's claim to enforce against the subject of the pledge on the grounds that the property specified in the annex to the pledge agreement was not in the possession of the pledgor at the time of the dispute.
In some cases, the court required the plaintiff (the creditor enforcing against the pledged property) to submit documents confirming the acquisition by the pledgor of property encumbered with a pledge, replacing the pledged property alienated by the pledgor (in particular, acts of inspection of the subject of the pledge, the pledge record book).
Changes in the Regulation of the Pledge of Revolving Goods
In conclusion, it should be noted that the current pledge legislation and the practice of its application are not sufficiently flexible, which affects the use of "dynamic" pledge (a pledge where the subject of the pledge is not fixed by individualizing characteristics but represents changing property or can be fixed at the moment of enforcement), under which revolving goods (and other property whose composition may change) can be pledged.
It appears that with changes in pledge legislation and its judicial application practice (particularly on issues of the content of the pledge agreement, enforcement against the subject of the pledge), companies with "revolving" property in their assets will be able to extract more value from it as property provided as collateral when attracting loans, as it will be valued by creditors at a much higher amount due to the reduced risk of loss of the subject of the pledge.