Rights of pledgee in enforcement event

As pledgee in an enforcement event, the bank would be entitled to sell the pledged shares or at least to avoid structural measures not in line with the bank’s interests and which according to the respective company law would require the consent of the pledgee.

Risk of subordination of loan and voidability of repayments

Under German law, such pledge of shares could however jeopardise the lender’s security position as follows: According to a decision of the Federal Court of Justice (Bundesgerichtshof, “BGH”), a lender could run the risk of being treated like a shareholder of the borrower, if (i) the lender is granted a pledge over the shares in the borrower and (ii) the loan agreement – as is often the case in structured and project finance transactions – contains a couple of covenants providing the lender with rights of co-decision (cf. BGH, ZIP 1992, 1300). The consequences of being treated like a shareholder can be severe:

• The loan would be subordinated like equity in an insolvency proceeding over the borrower’s assets (cf. sec. 39 para. 1 No. 5 German Insolvency Code); and
• any repayments of the loan made within 1 year before the insolvency application was made, would be contestable by the insolvency administrator (cf. § 135 German Insolvency Code).

Added value of a pledge of shares?

In view of these risks, lenders should carefully analyse if the advantages of a plegde of shares within the relevant transaction structure would really outweigh the risks associated with such pledge. Especially if the borrower is a special purpose company (SPC), a pledge of shares in this SPC may not be of great value for the bank in an insolvency related scenario. Not only would the sale of the shares be useless, since the value of shares in an entity which is insolvent (or close to insolvency) is equal to zero. But more importantly, in distressed scenarios investors predominantly tend to buy the SPC’s asset (e.g. ship, real estate etc.) instead of buying the shares in the SPC, since investors generally dislike to assume any liabilities of the insolvent SPC. Finally, being in a position to influence structural measures is neither an argument, since in contrast to an operating corporation of a certain size, an SPC may only rarely be subject to structural measures.

Conclusion

Lenders should generally refrain from accepting a share pledge over the shares in their borrower if that borrower is a German company and if the relevant loan agreement contains covenants providing the lender with rights of co-decision.

Alternatively, if the lender wishes to at least avoid the shares to be pledged to someone else, the lender could ask the borrower’s shareholder to provide the lender with a corresponding negative undertaking. Another possibility would be to incorporate in the loan agreement a clause, pursuant to which pledging the shares in the borrower constitutes an event of default.

Dr. Oliver Rossbach