The pledge of shares
The share pledge scheme is of underestimated complexity. This post names and shames the tools and modules to quasi-protect the foreign investor by a pledge of the shares of the Thai partner.
The purpose of a Co., Ltd. share pledge
In European civil law countries, the pledge has been widely replaced by a “transfer by way of security” or “chattel mortgage”. Such transfer of full ownership combined with a trust agreement avoids the disadvantages of the rigid and inflexible pledge regulations. However, Thailand does not have the trust concept, and the transfer of share ownership would be not allowed under Thailand’s foreigner legislation. Therefore, the pledge seems to be the next best thing. It can have different business purposes:
- It can give the lender a security for the repayment of a loan granted to the pledgor.
- It can protect the pledgor against a juridical enforcement by his third party debtors into his shares.
- A shareholder desires to get the shares of his co-shareholders economically under his control.
All aspect can be relevant in cases with a foreign investor and a Thai majority shareholder. The assignment (absolute or conditional) of the shares as contractual quasi-security is in such cases not possible because it would infringe Thailand’s foreigner laws.
The pledge of shares as real right
A share pledge is a contract whereby a shareholder, called the pledgor, delivers to the pledgee (and lender) the share certificates as security for the performance of an obligation, mostly a loan. The pledged shares must be kept in the physical possession and control of the pledgee at all time. The parties may agree that the pledged shares shall be kept by a third person.
The pledge is a “right in rem”, a real right. Its scope and size are not subject to the provisions of the pledge agreement. The parties can’t freely determine that the pledge should cover certain additional costs. The pledge is a security only for the performance of the obligation and for the following four accessories:
- Compensation in case of non-performance of the obligation.
- Costs of enforcement of the share pledge.
- Expenses for the preservation of the pledged shares.
Validity of the pledge
The share pledge is void unless
- the share certificates are delivered from the possession of the pledgor into the possession of the pledgee,
- the creation of the pledge is notified in writing to the company and
- the pledge is registered in the company’s share register.
A registration at the DBD Department of Business Development or other governmental consents or filings is not required to perfect a pledge. Stamp duty does not apply to the pledge, but to the related loan agreement stamp duties of 0.05% of the principal amount are due, maximum stamp duties THB 10,000. However, the validity of the loan does not depend on the stamp duties.
While the transfer of share ownership can be made by a paper transaction, the granting of a pledge requires a real action: This is the physical transfer of possession in the share certificates from the pledgor to the pledgee. This possession transfer can’t be replaced by a clause in the pledge contract that such transfer has been made if such statement is untrue.
The intention of the law (warning, clarity, publicity) is also not fulfilled if the company does not have any share certificates and such documents are prepared after the pledge has been agreed on paper. If the pledgee never had physical possession in the certificates, he could not transfer possession and the formal requirements of a valid pledge are not fulfilled. Simply said: Without share certificates any share pledge is void.
There seems to be no clear jurisdiction on the case that share certificates had been simply printed out after the pledge defaulted. However, it would be highly negligent and risky to trust such shortcut by avoiding the preparation of share certificates on time as explicitly required by the law. Even when a pledge gives much less as ownership, it’s formal requirements are higher.
If the loan and/or the pledge fall under the marital property regime of Thailand, it has to be carefully examined whether a pledge on a “Sin somros loan” (Section 1470 CCC) is legally effective and the purposes of the pledge can be achieved.
Elusive enhancements of the pledge
Because the law limits the size and scope of the pledge as real right, the parties can agree on other contractual arrangements in addition to the pledge. These are typically
- A power of attorney which gives the pledgee the authorization to vote on behalf of the pledgor in the shareholders meeting
- A dividend assignment, which assigns the dividend amount paid out on the pledged shares to the pledgee
- A voting commitment which compels the pledgor to vote in the shareholders meeting as instructed by the pledgee
- A share transfer call option of the pledgee which gives him the right to acquire ownership of the pledged shares
These additional agreements – whether concluded in separate papers or as additional clauses within the pledge contract – have to meet two legal requirements. The first hurdle is Section 756 CCC:
“Before the obligation is due, any agreement that the pledge shall, in case of non-performance, become the owner of the pledged property or disposed of it otherwise than in accordance with the provisions concerning enforcement of pledge, shall be invalid.”
The second hurdle are the provisions of the Foreign Business Act. While the pledge of shares alone does not change the qualification of a Co., Ltd. as Thai majority owned, the combination with the bundle of enhancements could be qualified by a Thai court as a contravention of Thailand’s foreigner legislation. In the best case, the pledge and/or some of these enhancements would be qualified as void. In the worst case, the company and its shareholders run into serious problems.
Enforcement of the pledge
The realization of the pledge does not result in an automatic transfer of share ownership to the pledgee. Instead, the enforcement of the pledge is made by a public auction by a licensed auctioneer, after written notification to the pledgor to perform his obligation and specifying to him the time and place of the auction.
There seem to be conflicting legal opinions whether the pledgee needs a court order to start the public auction or whether such involvement of the court, which easily requires one year time, is not legally required.
The proceeds from the public auction are paid to the pledgee after deduction of expenses and applicable taxes and stamp duties (if any), but not more than the outstanding loan amount. The surplus has to be paid to the pledgor. Therefore, the pledgor benefits from any rise in the value of his participation. As mentioned above, it is not allowed to agree in advance (before the occurrence of the default by the debtor) to enforce a pledge by foreclosing the pledged shares instead of selling the pledged goods by a public auction (Section 756 CCC).
The pledged 51% shares could be acquired even by a foreigner with the effect that the company is no longer entitled to carry out any business that falls under the Foreign Business Act. Or it has to apply for a Foreign Business License, which will in many cases be a mission impossible.
Under Section 760 CCC the pledgee is liable for any damages – even caused by force majeure – resulting from his use of the pledged property. Under which scenario the share pledgee is responsible for the well-being of the company, has to be examined on a case-by-case basis.
Unless otherwise provided by the contract, if the pledged property procedures legal fruits, the pledgee shall appropriate them in payment of any interest that may be due to him, and, if no interest is due, in payment of the principal of the obligation secured Section 761 CCC).
The limited value of a share pledge in a foreign investment scenario
If the foreigner sets up his company with common shares, a low equity amount (e.g. THB 2 million) and 51% Thai shareholding, the pledge secures just the loan (amounting THB 1.02 million) granted to the Thai partner for the acquisition of the shares.
In later years the company might have a much higher market value. If then the Thai shareholder stops to cooperate with the foreign investor, his/her pledged 51% shares might be sold in a public auction. However, all and any sales proceeds exceeding the loan amount have to be paid out to the pledgor, not to the pledgee.
The pledge of share does not protect the economic interest of the foreign investor in the pledged shares of the Thai majority shareholder.
A foreign investor, using the pledge of share as a protection mechanism in a Thai majority owned Co., Ltd. should be well aware, that he has no access to the market value of these 51% shares, but just to the nominal value. However, a sophisticated protection mechanism is possible to secure your shares in paradise.