Overview of the Six Most Important Changes to the Russian Pledge Rules

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1. Concept of a security trustee (security manager).

Given that the English-law concept of a 'trust' is not recognized by the Russian legal system, currently, under Russian law, only a creditor can hold the security for the debt. As a result, artificial creditor structures are often used to make Russian security viable in multi-creditor financing arrangements. For example, in syndicated loans, concepts of a "parallel debt" or a "joint and several creditor" are frequently used, even though these concepts have not been tested in the Russian courts and do not fit well in the Russian legal system. Secured notes (other than mortgage-backed securities, or "MBS") have not been very popular on the Russian market recently, among other reasons because of the lack of transparent mechanisms (such as trusteeship) for enforcing the security.

Starting from July 1, 2014, a creditor will, in the agreement, be able to appoint a security manager (trustee) who will hold the security on behalf of the creditors. The security manager will owe a fiduciary duty to the creditors and will be liable for breach of such duty. The creditors will be able to limit the amount of discretion that the security manager has in the exercise of his functions by stipulating reserved matters (any action on which must be approved by the creditors) in the security management agreement.

The new provisions on security trustees will supplement the new law on note trustees (please see our alert on Russian Note Trustee (a Bondholders' Representative) and Other Changes in Corporate Bond Regulations) which was adopted earlier this year and which will also enter into force on July 1, 2014. They should also extend and supplement the powers of special depositors (i.e., entities responsible for control of collateral (ipotechnoe pokritie) in Russian domestic MBS issuances). There is no doubt that the new concept of a security trustee will strengthen syndicated lending and asset-backed security ("ABS") structures involving Russian collateral and will bring the  Russian legal system into harmony with the most developed legal systems in the world in this area.

2. Pledges over bank accounts

After July 1, 2014, and subject to the adoption of the necessary regulation by the Russian Central Bank, a person will be able to create a security interest over a bank account. To make use of this long-awaited option, parties will be required to use a specific type of account – a "pledge account."

It will be possible to create the security interest over either the whole of, or part of, an account balance, and even over an account that, at the time of entering into the pledge agreement, has a zero balance. The account holder will not be able to close the pledged account or give the bank payment instructions which are inconsistent with the terms of the pledge agreement, without the authorization of the pledgee. In addition, the pledgee may, in the pledge agreement, authorize the bank to monitor withdrawals from the pledge account. For this purpose, the bank will be required to disclose to the pledgee certain information related to the pledged account, including information on the balance of the pledged account.

Enforcement of the security will be possible by means of direct debit from the account in favor of the pledgee.

3. Unified register of pledges over movable property

The public unified register of pledges over movable property (the Register) was initially introduced by Federal Law No. 166, dated October 2, 2012 (for detailed information please see our alert on Registration of Pledges of Movable Property). Later amendments to the Civil Code introduced more detailed regulation on registration of such pledges in the Register. A failure to register a pledge agreement in the Register does not affect the validity of the security, but such registration gives the pledgee some additional defenses against third parties. For example, (i) the registered security interests will take priority over unregistered security interests and (ii) the registration will allow the pledgee to make use of the "bona fide purchaser" defense.

By introducing the registration of pledges over movable property, Russian law will effectively switch from the "registration against a particular debtor" system to the "registration against a particular asset" system in this area. This change should relieve pledgors of the necessity to keep their own pledge books – a system which has proved in practice to be an ineffective method of perfection. It should also reduce the risks faced by security holders in relation to the fraudulent sale of encumbered assets and the manipulation of claim priorities by way of backdating of the security documents.

4. Floating charges

Under current Russian law and court practice, a pledge agreement must refer to the individual identifying features of the pledged property, or, in the case of property that is not unique, its generic features. The new law will permit the identification of pledged assets by reference to a person (the pledgor will be able to pledge all or part of a set of individually identifiable property as a whole, without describing each separate item). Taking into account that the moment at which the security interest attaches to the property (i.e., the crystallization of a floating charge) can be regulated contractually, this new approach will permit the use in the Russian law environment of security structures similar to the English-law concept of a floating charge. It could be argued that there is a risk of such a pledge structure being challenged as suspicious by a receiver, given that the security interest will frequently arise close in time to, or simultaneously with, the opening of the pledgor's insolvency. However, even despite this risk the quasi-floating charge can be considered a useful additional security instrument in lending and structured finance, which will provide creditors with a higher level of assurance in the areas not covered by the main security.

5. Pledgee's liability

Current legislation does not provide sufficient protection to the pledgors in the event of extrajudicial enforcement of the security. A new law introduces new standards of liability for the pledgee.

Firstly, the concept of a pledgee's fiduciary duty has been introduced. For example, the pledgee will have a duty to sell the pledged property at the best available price. The pledgor is entitled to damages for any loss which it incurs as a result of the pledgee's breach of its fiduciary duty. On the other hand, the new law does not give clear guidance as to what the best available price is. This question is a matter of fact, which will have to be determined by the court on a case-by-case basis. It may be argued that damages for the violation of the fiduciary duty by the pledgee may not be an effective remedy, as the amount of the losses incurred may be difficult to prove.

Secondly, a court may, at the pledgor's request, rule that out-of-court enforcement be replaced with a public tender, if it is demonstrated that the pledgor's rights have been breached (or that there is a substantial threat that they may be breached) by the pledgee. There is a risk, however, that without a clear definition of the term "substantial threat," this new rule may be abused to avoid compliance with the terms and conditions of the pledge agreement.

6. Priority of Security Interests

Although Russian courts have in certain cases recognized agreements between secured creditors on the distribution of proceeds of enforcement (see para. 8 of Presidium Decision No. [50] of the Higher Commercial Court, dated [ .2005]), it has been generally questionable whether such an agreement can be enforced in Russia. Starting from July 1, 2014, pledgees will be expressly permitted to agree on priority of their security interests, unless such an agreement would affect the rights of third parties. The proceeds of enforcement payable to pledgees with equal priority are to be distributed between them on a pro rata basis, unless otherwise agreed by the pledgees in question.

Topics:  Bank Accounts, Banks, Debt, Debt Collection, Russia

Published In: General Business Updates, Finance & Banking Updates, International Trade Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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