Pledges on movable goods are a traditional form of security that is well suited to debtors that have no access to other forms of security, such as a guarantee provided by a third party (eg, bank guarantee) or the mortgage of real estate. However, the pledge under Swiss law raises practical difficulties in the light of a recent Federal Supreme Court decision.
In rem secured rights under Swiss law are governed by the numerus clausus principle, pursuant to which no form of property right other than those established by law (mainly the relevant titles of the Civil Code) may be agreed on by the parties. Insofar as movable goods are concerned, the main form of collateral is the pledge pursuant to Articles 884 and following of the Civil Code. The most salient feature of the Swiss law on pledges, which distinguishes such collateral under Swiss law from similar instruments in other jurisdictions, is the principle contained in Article 884(3) of the code whereby no pledge is validly constituted if the pledgor retains possession over the pledged assets. A condition for perfection of the pledge is thus the transfer of possession of the assets to the pledgee or to an agent of the pledgee. The rationale for this provision, enacted in 1907, lies in the protection of third parties, which should not be misled by the erroneous appearance that the debtor fully owns the assets that it possesses.
However, the legal requirement that possession be abandoned is difficult to reconcile with the practical needs of the debtor. In a commercial context, a company that wished to use its assets (stock and inventory) as security to obtain a loan would be compelled, in order for the pledge to be perfected, to abandon control over those assets. The practical difficulties that can arise render the Swiss pledge much less attractive than similar instruments under foreign law (eg, a floating pledge). A recent decision of the Federal Supreme Court(1) illustrates these difficulties, although the outcome for the beneficiary of the pledge was eventually satisfactory.
A foreign investor, through a company owned by him (the parent company), acquired the entire share capital of a well-known Swiss manufacturer of high-precision machines (the debtor), which had a prestigious history, but had also experienced repeated financial crises and bankruptcies. In order to provide the debtor with the requisite working capital, the parent company extended repeated loans at a time when the situation was already quite critical. The question that arose was what sort of collateral could be provided by the debtor as security for the significant loans that were being granted by the parent company.
The only assets that could be identified for this purpose were some machines that had been manufactured by the debtor and that were either finished or largely completed. The practical difficulty that the lender and the debtor had to address was how to comply with the legal requirements for a valid pledge under Swiss law - namely, the dispossession of the debtor. The machines that were to be the object of the pledge were heavy and fragile objects that were difficult to move and that had to be stored under specific conditions. Removing the machines from the debtor's premises and storing them in a different location was therefore not a viable option. It was thus decided that the machines would remain in the debtor's warehouse without being displaced from their location, but that locked fences would be erected around the machines. In addition, large notices were placed on the fences indicating that the machines were pledged in favour of the parent company. Notably, the foreign investor - the sole shareholder of the parent company and the ultimate economic beneficiary of the company - was also the chairman of the debtor's board of directors.
Despite this financial support granted by the parent company, the debtor found itself in a situation of over-indebtedness, which led the competent Geneva judge to isue a declaration of bankruptcy.
The parent company, as creditor of the debtor, claimed the amounts of the loans in the bankruptcy proceedings and invoked the right to be treated as a secured creditor with respect to the pledged machines. The bankruptcy office denied the claims of the parent company and refused to consider that the latter was a secured creditor. The parent company filed an action before the Geneva courts to challenge the schedule of claims that refused to consider it as a secured creditor, and the matter was ultimately brought before the Federal Supreme Court.
The first substantial issue reviewed by the Federal Court was whether the requirement of the dispossession by the debtor was fulfilled in the present instance. The bankruptcy office had held that this requirement was not fulfilled since the debtor could have broken the locks and/or removed the fences – there were some cranes alongside the machines that might have been used – and thus gain access to the pledged machines. In other words, the measures taken by the parties were insufficient to constitute an abandonment of possession by the debtor.
The Federal Supreme Court rejected this argument. It noted, from a factual point of view, that the protective measures put in place could not be considered as being purely symbolic. More significantly, the Federal Supreme Court found that removing the locks and fences would have been possible only by causing damage to the property (breaking the locks and fences) or through clandestine operation of the cranes to remove the fences - either of which would have amounted to a breach of the Criminal Code. In other words, to the extent that the debtor could have regained possession of the pledged machines only by committing a criminal offence, the judges of the Federal Supreme Court reached the conclusion that the pledgor had indeed abandoned possession.
The second ground invoked by the bankruptcy office for refusing the validity of the pledge related to the dual functions of the ultimate shareholder, who was both the parent company's beneficiary and the chairman of the board of directors of the debtor, the pledgor. Therefore, according to the bankruptcy office, the debtor had maintained access to the pledged machines to the extent that the keys for the locks were kept by an individual who was a director of the debtor.
The Federal Supreme Court reiterated in this context that a valid pledge presupposes a transfer of possession. What is required under Swiss law is not that the pledgee acquire exclusive possession, but that the pledgor lose exclusive possession. Referring to the existing case law and the opinions of scholars, the Federal Supreme Court indicated that the purpose of this rule is not only to ensure the publicity of a right of pledge with respect to third parties, but also to avoid a situation where the debtor is in a position to constitute a new pledge on the same assets in a manner that would be detrimental to the first pledgee.
As a matter of principle, the Federal Supreme Court considered that a representative of the pledgee cannot at the same time be a representative of the pledgor, since this would confer on the pledgor a right of control over the pledged asset which is not permissible under Swiss law. However, there is an exception to this principle whenever the representative of the pledgee has possession of the pledged asset and, as the case may be, can prevent an act of disposition by the pledgor.
In the case at hand, as regards the dual function of the ultimate shareholder, the Federal Supreme Court held that there was no risk that he would have wished to exercise his functions – and thus his control over the pledged asset – for the benefit of the debtor. Indeed, to the extent that he knew the debtor's vulnerable financial situation , the ultimate shareholder, in his capacity as director of the debtor, would have had no incentive whatsoever to dispose of the security in favour of anyone else. In other words, although the ultimate shareholder could indeed act on behalf of both parties, the judges of the Federal Supreme Court found that the interests at stake (ie, maintaining a security for the loans extended) were sufficient to ensure that the ultimate shareholder would exercise his right of control over the pledged asset as a representative of the pledgee, and not of the pledgor. Consequently, the pledgor was deemed to have abandoned exclusive possession of the asset so that a valid pledge under Swiss law was created.
In this particular case, the Federal Supreme Court ruled that a valid pledge under Swiss law was constituted even though the machines remained on the debtor's premises. However, the outcome should not affect the general view that the Swiss law pledge is not well suited to the stocks and inventory of an enterprise. In addition to the practical difficulties relating to the abandonment of possession by the pledgor, this decision illustrates the difficulties that arise in situations – which are not uncommon whenever the creditor and the debtor are related entities – where the same person acts for both the pledgor and the pledgee.
From a practical standpoint, this decision calls for the following recommendations:
- To the extent possible, the pledged assets – if they are not remitted to the pledgee – ought to be clearly segregated from the pledgor's other goods to avoid debate as to whether the pledgor validly abandoned possession of those goods.
- Access to the pledged assets should be conferred on a person who is contractually bound to the pledgee exclusively, and not to the pledgor.
For further information please contact Daniel Tunik or Ilir Cenko at Lenz & Staehelin by telephone (+41 58 450 7000), fax (+41 58 450 7001) or email ([email protected] or [email protected]).
(1) Decision by the Federal Supreme Court dated August 13 2009, 5A_315/2009.