What is a Contract of Pledge?
A contract of pledge is a contract in which the debtor undertakes to deliver a movable asset to the lender, which the latter binds himself to return to the debtor as soon as the principal and its interests are paid or the obligation is performed.
It differs from a sale where the seller is obliged to transfer thing to the buyer, who binds himself to pay the price. It is also distinct from a loan for consumption since it is the lender who gives something to the debtor.
French scholar and lawyer Jean Domat (1625-1694) explained it as such: the creditor does not enter into possession of the thing pledged, without he having a disposition over it.
A security or a guarantee: This definition refers to a guarantee offered by the debtor based on a movable asset that it controls. As a consequence, if the debtor breaks its commitment, the creditor can satisfy its obligation from the asset pledged.
The contract is regulated by the law of obligations and contract law. A contract’s essential elements are offer, acceptance and consideration.
There are different kinds of contracts of pledge: a contract of pledge on asset in possession of the debtor, a contract of pledge on asset in possession of a third party and an account pledge contract .
Pledge on assets in the possession of the debtor. The asset pledged remains in the debtor’s possession. The lender has the right to compel the debtor to deliver the asset pledged, without prejudice to the debtor’s ability to retain it (Art. 2276 Civil Code). For example, under a loan agreement, the lender is accepting money but the debtor offers its balance on an account as a pledge, to cover the loan if something goes wrong. The lender thus has the right to keep the assets he received in pledge in order to satisfy his claim, unless the debtor fulfills his obligations.
Pledge on asset in the possession of a third party. Under this contract the debtor can neither retain possession of the asset nor deliver it freely to a third party. The asset must be delivered to the lender before the essence of the contract is created (Art. 2072 Civil Code). For instance, a company may take a loan and agree to hand its business to the lender if its obligations are not met.
Account pledge contract. An account pledge contract is integrated when a debtor decides to open a bank account, but pledges the funds inside. This enables the debtor to ensure the fulfilment of an existing debt. The debtor can provide a payment order in order to withdraw its funds.
Essential Elements of a Contract of Pledge
The fundamental terms that are required in a contract of pledge should include:
Parties to the Pledge
a. Name of the pledgor and their registration number (if applicable)
b. Address of the pledgor
c. Name of the pledgee and their registration number (if applicable)
d. Address of the pledgee
Description of the pledged asset
a. Name of the pledged asset (if applicable)
b. Registration number of the pledged asset (if applicable)
c. Cognomen of the pledged asset (if applicable)
d. Models and sizes of the pledged asset (if applicable)
Term of the Agreement
a. It is advisable to define the period for which the pledge will be enforceable (for instance, ten years)
b. The parties need to establish the deadlines for the performance of the obligations secured by the pledge
c. Create specific dates and periods in the contract
Contract Conditions
a. Terms of the contract
b. Terms for the termination of the contract
Default Provisions
a. Default events
b. Rights and responsibilities of the pledgor and pledgee relative to the pledge
c. The role of a court system and arbitration
Arbitration Clause
The Parties may agree to include an arbitration clause in the contract as a way to minimize disputes and avoid extensive litigation. In this case, the parties will endow the Arbitral Tribunal with the authority of the court to adjudicate disputes between them.
Legality and Legal Considerations
To ensure the effective enforcement of rights under a contract of pledge, certain legal requirements and common considerations must be taken into account and understood. When a contract of pledge relates to property that is movable (either tangible or intangible), a notarisation is the only requirement under South African law.
For a contract of pledge over property that is immovable, however, it must be registered against the property in the Deeds Office in order for a pledge over immovable property to be valid and enforceable against third parties. The registration of the deed of pledge in the Deeds Office records the pledge for all to see and clients should be encouraged to protect their rights in this way for further security.
In addition to the above requirements for movable and immovable property, certain other considerations should be kept in mind when drafting any contract of pledge.
The liquidiation of the pledgor before enforcement or fulfilment of a pledge agreement may suspend the execution of the pledge against third parties. It would be advisable to state expressly in the contract that a right of retention and other rights of an pledgor will not be suspended by execution or fulfilment or the insolvency or winding-up of the pledgor.
It is also suggested that the parties make the provisions of the Consumer Protection Act 68 of 2008 ("the CPA") applicable to the contract of pledge so that it is approved and compliant with the CPA. The parties may well find it easier to administer or enforce a contract that is compliant than one that is not.
Sample Template for a Contract of Pledge
Sample contract of pledge
In this section, we provide you with a sample contract of pledge which you can use as a reference point.
This is an example of a contract of pledge which can be entered into for the purpose of creating a pledge on stocks.
Contract of pledge
THIS CONTRACT OF PLEDGE (hereinafter referred to as the "Contract") is executed at _______________ on this ___ day of _________, 20___ between (1) A, S/o________, aged about ___ years, _______ and having his address at _________________ (hereinafter referred to as "Pledgor"), and (2) B, S/o___________, aged about ___ years, _______ and having his address at ____________ (hereinafter referred to as "Pledgee").
WHEREAS the Pledgor is owner of such shares as specified in the schedule below (hereinafter referred to as "Shares") offered for a pledge to the Pledgee as described hereinafter.
AND WHEREAS, the Pledgee has agreed to act as a custodian of the pledged Shares for the period of time and on the terms and conditions as per this Contract.
AND WHEREAS the security provided by the Pledgor to the Pledgee as per this Contract is solely for the purpose of discharging of lawful dues owing by the Pledgor or by any associated persons to the Pledgee.
AND WHEREAS it is the intention of the Parties that the Pledgee shall hold and/or deal with the pledged Shares in any manner permitted hereinafter and in accordance with the provisions contained herein.
NOW THEREFORE in consideration of the mutual covenants, representations and warrants made herein by and between the Parties hereto, each intending to be legally bound hereby, it is agreed as follows:
- The Pledgor hereby pledges the said Shares to the Pledgee on the terms and conditions set forth herein and/or as may be notified to the Pledgor by the Pledgee from time to time in writing (or by telegraphic, electronic or fax transmission) in which events the same shall be deemed to form integral part hereof.
- The Pledgee hereby accepts the pledge on the terms and conditions set forth herein and as may be notified to the Pledgor by the Pledgee from time to time in writing (or by telegraphic, electronic or fax transmission).
- The Pledgor agrees to give to the Pledgee notice of any change in address of the Pledgor or any of the terms, which may affect the pledge of the Shares to be held by the Pledgee.
- The Pledgor agrees to register the Pledge with the Registrar through share transfer forms as may be returned by the Pledgee and at the costs and expenses of the Pledgor.
- The Pledgor agrees that subject to compliance with the provisions of the Companies Act, the Pledgee shall have the right to exercise the voting rights attached to the pledged Shares during the continuance of the term of this Contract.
- The Shares subject to the Pledge shall not be released by the Pledgee until (i) all amounts payable by the Pledgor to the Pledgee under any loans have been duly paid and discharged or (ii) upon the written termination or expiry of this Contract.
- (a) The Pledgee shall be entitled to deal with the pledged Shares as per the provisions of Section 176 of the Indian Contract Act, 1872 (2 of 1872), as amended from time to time.
(b) The stock exchange authorities, depositories, clearing/custodial agents, registrars or other authorities, companies or persons concerned with the administration of the system of depository transfer and/or dematerialisation of the Shares shall be entitled to act in accordance with the instructions given by the Pledgee pursuant to the provisions of paragraph (a) above.
- The Pledgor make no representation or warranty whatsoever in respect of the pledged Shares or the associated persons except as expressly set forth in this contract or in any of the documents delivered pursuant hereto.
- This Contract shall be terminated only on expiry or upon the Pledgee receiving all sum due by the Pledgor in compliance with the instructions given by the Pledgee as mentioned above and/or in compliance with the terms and conditions set forth herein.
- This Contract shall be governed by and construed in accordance with the laws of India. The courts at __________ shall have exclusive jurisdiction to entertain any applications arising from or out of or touching this Contract.
Common Errors in Creating a Contract of Pledge
A common error is not spelling out how the value of the pledged asset should be calculated. While the Law does provide rules for the calculation of values for the purposes of resolving potential disputes, these rules may not align with the intentions of the parties, or particular circumstances. Another error involves specifying that the pledge may, or will, be executed only in Nashville. The Law states that perfection of a pledge of tangible moveable property is governed by the laws of the jurisdiction in which the property is located at the time of perfection. In contrast, perfection of a pledge of receivables is governed by the laws of the jurisdiction specified in the contract. In many cases, including a pledge of shares or other moveable property, the relevant jurisdiction will be the place where the moveable property is located. Thus it may not be possible, or judicially convenient, to specify that the pledge will be executed in Nashville, as opposed to the place in which the property is located. Selecting the proper location is particularly important, as the pledge will not be effective under the Law if it is not perfected , and the pledge may not be valid under the laws of a foreign jurisdiction such as Germany. Other mistakes occur when the scope of a pledge is not clearly defined. A pledge of intangible property without additional detail is ambiguous. Such a pledge must define the assets to be pledged, as well as how the securitised loans will be perfected in each jurisdiction, in order to ensure that the pledge meets requirements for a valid security interest under the laws of the relevant jurisdictions (such as China, whose central bank would need to approve the perfection of any such security interest). Make sure that the contract of pledge has been signed by all required parties, and that they have the requisite authority to do so. If the property being pledged is owned by someone other than the debtor, the owner must consent to the creation of the pledge, which must then be registered with the appropriate house mortgage registry to ensure that the pledge will be effective against third parties. It is important to note that any amendments to or novation of the contract of pledge will require a new contract of pledge, as registration of a contract of pledge made with respect to certain moveables property issued with a face value of RMB2 million or above may be revoked if the contract is amended without any further registration.
Advantages and Disadvantages of a Contract of Pledge
From the perspective of the pledgee, a contract of pledge provides the comfort of a secured loan, because in case of default on an obligation by the pledgor, the pledgee has the right to sell the object of the pledge and recover the amount owed to him out of the proceeds of the sale. However, the remedy of sale cannot be exercised directly by the pledgee without assistance from the court. In this regard, the pledgee generally has to obtain a court order allowing him to sell the pledged object. The pledgee can only take possession of the pledged object (assuming that he does not have possession already) for the purposes of keeping it in good condition or for the safety of the object, if it is perishable. If the pledgee goes beyond his rights under the contract, the pledgor may make a claim against him for any damage caused.
From the perspective of the pledgor, a contract of pledge allows him to obtain a loan at a lower interest rate than that available to him as an unsecured borrower, as the lender does not face the same risks when it has the benefit of a security deposit. However, the downside for the pledgor is that its assets are pledged and cannot be given as security to another lender for the purposes of raising further capital (unless the first lender agrees to such further charge).
Frequently Asked Questions
Q: What is a contract of pledge?
A: By entering into a contract of pledge, you can fairly easily securitize your debt obligations by providing your creditors with a guarantee of payment in kind. Contracts of pledge are regulated by the Commercial Code (CC), assuming they are created between merchants in the course of their trade and business activity. Moreover, contracts of pledge are also regulated by special statutes. These special statutes include the Intellectual Property Act, the Patent Act and the Copyright Act.
Q: What types of items can I pledge?
A: You can create a contract of pledge internum in respect of any movable asset (animals , equipment, etc.) as well as a contract of pledge externum in respect of immovable assets (land, buildings, etc.).
Q: What is the procedure for entering into the contract?
A: The contract of pledge must be in writing. If the subject of the pledge is real estate, the parties will enter into a notary deed. The government then registers the contract in the Commercial Register in respect of the pledger’s company designation. If the subject of the pledge is not a real estate item, the contract does not have to be in writing.