Pre-agreed releases and Swedish law – when does a security stop being a security?

1. Rights in rem Issues

A core part of the Swedish credit market consists of pledges where shares are pledged as security for debt. Frequently, pledgors request the possibility to transfer pledged shares at the pledgor’s request without the pledge continuing to encumber the shares to e.g. sell the shares at a market-favourable time or to transfer a wholly-owned subsidiary and its business.

The prerequisites for a pledge to be valid under Swedish law are, firstly, the individualisation of the pledged asset to such an extent that the object can be identified, and secondly, the performance of a proprietary act that deprives the pledgor of its control over the pledged asset. The issue at hand regarding the pledgor’s right to transfer pledged shares is whether it can be considered within the pledgor’s power to obtain such a unilateral right, and consequently, whether a contractual obligation for the pledgee to release the security jeopardises the validity of the pledge.

The problem with a clause whereby the pledgee is obliged to release the security at the pledgor’s request is that, by its nature, it gives the pledgor a decisive influence over the pledged asset. If the pledgor can effect a sale at any time, the pledgee’s possession and/or control is merely formal, and the perfection of the pledge risks being undermined. The prevailing Swedish view is therefore that such a set-up contravenes the requirement of dispossession (Sw. rådighetsavskärande) and thus, does not create a valid pledge. In practice, , related ways to deal with this legal issue have been developed.

2. The Problematic Nature of the Contractual Term

The central purpose of dispossession is not to mechanically prohibit all forms of influence by the pledgor, but to ensure that the pledgee cannot be misled, that the value of the pledged asset is not jeopardised, and thus, that third party creditors do not lose their protection. If these purposes can be maintained through other mechanisms, the mere right to request the release of the security does not necessarily need to invalidate the pledge.

Hence, the key issue lies in the legal requirement of dispossession under Swedish law. The requirement includes a general prohibition for the pledgor to continue to dispose of the pledged asset, with exceptions for minor interventions in the object approved by the pledgee, in order to counteract sham transactions and post hoc constructions. The obligation for the pledgee to release security must therefore not enable fraud amongst creditors.

Another way to view security pledges is as a means of securing the value of the security for the pledgee. Given the prohibition against forfeiture pledges under Swedish law, the pledgee does not have a direct interest in the pledged asset as such. The interest in the security instead lies in the value that the pledged asset represents. The obligation for the pledgee to release security must therefore not jeopardise the value of the pledged asset.

3. Possible Clausal Formulations

Below we have set out two examples of clauses for future releases, where the first example could jeopardise the validity of the pledge while the second example upholds a valid pledge agreement:

“The security shall be released immediately, at the pledgor’s request, without any obligation for the pledgor to pay the purchase price to the pledgee or to perform towards the pledgee in any other way”

It is evident that this wording both potentially enables creditor fraud and jeopardises the validity of the pledge. The pledgee becomes a mere custodian of the pledged shares as it has no control over any future disposal of the shares and is not guaranteed any repayment in connection with such a disposal. In other words, the shares are merely deposited with the pledgee while the actual control remains with the pledgor. As this construction enables an indebted debtor to pledge the shares merely as a formality to either evade enforcement against its other assets or claim that such a pledge has occurred at a later stage, the protection against creditor fraud is not upheld. Furthermore, as the pledgee is not guaranteed any compensation from the pledge itself, the arrangement also fails to safeguard the pledgee’s interest in the value of the pledged asset. Taken together, the formulation cannot therefore be considered to provide a valid pledge.

“The security is to be released immediately, at the pledgor’s request, and the pledgor shall repay the outstanding credit secured by the security”

This clause stipulates that the pledgor shall pay or transfer the sale proceeds to the pledgee before, or simultaneously with, the release of the security. This means that the pledgee will at all times have security and that the economic substance of the pledge (i.e., the value guaranteeing the creditor’s claim) remains unchanged. Such a construction is considered consistent with the fundamental functions of proprietary protection. It maintains creditor protection as the pledgee at all times has access to a corresponding value of the secured asset and it counteracts sham transactions as the release of the security can only occur against immediate payment.

4. The remaining uncertainty

It should, however, be emphasised that the legal situation remains uncertain until the issue is appealed and settled by the Supreme Court or regulated by law. Until then, parties wishing to introduce clauses to the effect that security is to be released given certain circumstances, such as repayment of the secured debt, should draft such clauses with great caution, clearly regulate payment flows, and ensure that the pledgee’s rights are not eroded.