Whether or not a pledge over shares in an onshore LLC is worth the paper it is written on is a question that has troubled UAE practitioners and their clients for years. In this article we examine the previous legal position and analyse what will change now that the new Companies Law (Law No. 2 of 2015) (the New Law) has come into effect.
Share pledges are an important topic to banks and other financial institutions in that, in theory, they allow a lender to take control of a company. Pledges are also of significance to foreign investors choosing to incorporate an LLC in the UAE. The foreign investor will often lend the amount of the capital to the UAE national shareholder to enable it to acquire its 51% interest. The foreign investor usually wants to secure that loan, and its investment more generally, by careful structuring, which may include taking security.
The previous position
Under the previous Commercial Companies Law (Law No. 8 of 1984) (the 1984 Law) there was considerable debate amongst lawyers as to whether a shareholder in a UAE LLC was able to pledge its shares. This debate focused on both the legal technicalities as to whether a pledge of LLC shares was possible, and the practicalities of registering and enforcing the security.
First, it is important to understand that an LLC's "shares" are not financial instruments, but instead are akin to partnership interests. Many civil jurisdictions have a similar form of corporate entity, in relation to which the "shares" are often referred to as "quotas".
Linked to this is the question of how a pledge may be perfected over such an interest. Under the 1984 Law, there was no requirement for a LLC to issue a share certificate and, even if one was issued, it did not of itself represent title to the LLC interest. Under the UAE Commercial Code, a commercial pledge requires that the creditor take possession of the moveable asset which is subject to the pledge, or holds a deed which represents the mortgaged asset. Similarly, under the Civil Code, a possessory pledge also requires the creditor to take possession of the pledged item.
The Economic Department in Dubai (DDED) developed its own approach to some of this uncertainty in recent years. The DDED accepted the registration of notarised pledge instruments in respect of LLC shares in favour of UAE Central Bank regulated financial institutions, and also permitted LLC shares to be listed as one of the assets secured as part of the registration of a commercial mortgage in favour of such institutions. Pledges in favour of foreign financial institutions, private companies or individuals were not, however, accepted. Foreign lenders therefore had to instruct a local bank to act as security agent, while private companies and individuals were generally unable to register their security. In practice, however, most lenders did not create or rely upon a pledge over LLC shares as part of their security package, due to the costs of perfection and the legal uncertainties surrounding the pledge.
There was also the question of enforcement. Self-help remedies are not generally available under UAE law. A UAE court order was required to levy execution on the shares, which generally resulted in the shares being sold by way of public auction where bidders were restricted to UAE nationals. A lender may have sought to address this through a security power of attorney allowing it to sell the shares. However, UAE government departments, public notaries and courts will not enforce any power of attorney unless it is notarised. Generally, it is not possible to grant an irrevocable power of attorney in the UAE, although the public notaries may allow an irrevocable power of attorney as part of a lawful security package.
There were two further significant company law obstacles to the creation of a LLC share pledge under the 1984 Law, both of which remain under the New Law:
- statutory pre-emption rights apply for the benefit of other shareholders in the LLC in respect of transfers. It is not possible for a general waiver of such rights to be entrenched into the company's Memorandum of Association (MoA) because the public notaries will not notarise the document. It is only possible to waive the rights in response to a specific situation with all shareholders in attendance at the public notary. These rights may give other shareholders considerable negotiating power in respect of any private sale process on the exercise by a lender of its security; and
- the UAE's foreign ownership restrictions limit the pool of potential buyers in a private sale process. They also restrict the ability of a foreign lender to take the title to the shares itself in many situations (including in a typical 'protective scheme' in a 51/49 per cent. owned LLC).
The New Law
Article 79 of the New Law expressly permits shareholders in LLCs to pledge their shares. Any such pledge must be made in accordance with the company's MoA, under an official notarised document and entered into the Commercial Register maintained by the Department of Economic Development (DED) in the relevant Emirate.
This provides welcome clarification of the legality of pledges of LLC shares. However, there are several practical issues which will need to be addressed before taking security by way of LLC share pledges is commonplace:
- Perfection of the pledge – the New Law still does not require a share certificate to be issued which may be retained by the creditor. The fact that there is no document which represents title to the LLC share interest means that it is unclear how an LLC share pledge fits with the currently available types of pledges under the Commercial Code and Civil Code which require actual or constructive possession. From a practical perspective, however, the MoA may require a note of the security to be made in the company's internal register of partners as some protection for the creditor in relation to the creation of competing security interests and unauthorised share transfers.
- Notarisation and registration – we understand that the DEDs across the UAE are currently putting into place systems to enable registration of pledges. However, it is not yet clear whether the public notaries and the DED will permit the registration of pledges in favour of any party, not just UAE Central Bank regulated institutions. Note that there is no plan for the Commercial Register to be open to public inspection and, unless this situation changes, it will be difficult for a prospective creditor to be certain as to prior competing interests without the co-operation of the LLC. However, the New Law does establish basis for a new Companies Registrar which will hold certain corporate documents. Further implementing regulations are expected in relation to the new Registrar. It is possible that some degree of access to a company's key information, such as the current MoA, will be granted to interested parties (such as a prospective buyer or creditor in respect of shares).
- Priorities - the question of priorities as between pledges is not clear. Article 79 provides that a pledge is not valid against the LLC or third parties until the date of its entry in the Commercial Register; once registered, however, is it the date of creation of the pledge or the date of registration which will determine priority?
- Enforcement - Article 81 provides that a creditor commencing attachment procedures against the shares may agree with the debtor and the company as to the method and terms of the sale, otherwise the shares shall be offered for sale by way of court-controlled public auction. The shareholders will have the right to buy back the shares from the winning bidder in an auction scenario within 15 days of such auction on the same terms and conditions. This does not constitute a self-help remedy as the agreement of third parties is required in order to obtain the shares or the cash equivalent to recover the debt due. In particular, how the statutory pre-emption provisions and foreign ownership restrictions will operate in this context is unclear.
- Financial assistance - the New Law introduces a prohibition on joint stock companies (JSCs) and their subsidiaries providing financial assistance to fund the acquisition of their own shares. Financial assistance is widely defined and includes assistance given by way of security, such as pledges. There is some market discussion on the application of this provision, in particular because Article 104 of the New Law applies all of the JSC provisions to LLCs unless the Law provides otherwise, although the wording of the financial assistance prohibition refers in Arabic to JSC shares, not LLC interests. We believe that this prohibition is intended to apply, at least, to an LLC providing financial assistance (as a subsidiary) for the acquisition of a JSC's shares. Therefore, a pledge over an LLC's shares as part of a security package for an acquisition finance transaction in respect of a purchase of shares of its JSC parent is likely to be prohibited under the New Law. In contrast to other jurisdictions, there is no statutory 'whitewash' procedure in respect of private companies and there are no general exemptions such as, for example, where the giving of the assistance is only an incidental part of some larger purpose and the assistance is given in good faith in the best interests of the company.
Note also that, under Article 154 of the New Law, the board of directors of a JSC may not have the inherent power to pledge its shareholding in an LLC. The New Law requires that, in order to pledge movable property (which may capture an interest in an LLC), the power to do so must be in the MoA or one of the objects of the company - otherwise specific shareholder approval is required.
Although it is at least now clear that pledges of LLC shares are legally possible and can be protected through registration, various critical matters remain to be clarified in practice before it can truly be said that pledges of LLC shares constitute a valuable security.