‘Debtor pledged unauthorized construction. How did the creditor protect his rights.’ Article by S&K Vertical project manager - Andrey Kornitskiy for ‘Arbitrazhnaya Praktika’

23 august 2018

Pledgers often recourse to bad faith actions in order to escape execution being levied on the collateral. In case № А40-46238/2016 a building which turned to be an unauthorized construction was pledged to a bank. Supreme Court helped protecting creditor’s interests. 

Background

Bank and the borrower entered into a credit contract. Building mortgage agreement was made between them as a collateral. The borrower failed to repay the credit, and the bank recourse to a district court which resolved to recover the debt by levying execution on the pledged assets. Not long before the above ruling was rendered, the pledger contested mortgage agreement. He claimed that the building meets unauthorized construction criteria, and also referred to a breach of the procedure for approval of major transactions when agreement at issue was made.

Bank's arguments

Objecting to the pledger's statements, the bank argued as follows:

1. Pledger’s claims relate to having the mortgage agreement held void. Due to this, the court is not entitled to consider claims related to declaring the building an unauthorized construction.

2. The bank did not know and shouldn't have known that this agreement was a major transaction for the company which hadn't been duly approved. Mortgage agreement was signed by the pledger’s CEO who also acted as the sole shareholder. This fact was confirmed by statements from the shareholder register and articles of association, as well as by resolution of the sole shareholder on entering into mortgage agreement. Therefore, in accordance with s. 3 Article 78 of the Federal Law on Joint-Stock Companies dated 26.12.1995 №208-ФЗ (hereinafter referred to as the Law on JSC) provisions on approval of major transactions shall not apply in this case. 

3. Pledger abused its rights. First, as at the date of the mortgage agreement actual floor-space and number of storeys, as stated in the register, did not comply with construction permit data. However, pledger concealed this information from the bank. Secondly, when entering into the mortgage agreement pledger produced documents which evidenced that one and the same person acted as the company's sole shareholder and CEO. However, later on other statements from the shareholder register and ledger of the company were produced in court, according to which another person acted as the company's shareholder.

Ruling by the court of first instance

Court of first instance granted the pledger's claims. The court took into account that actual floor-space and number of storeys in the building did not meet construction permit data. Therefore, provisions of Article 222 of the Civil Code of the Russian Federation were breached when making the agreement, since the above provisions prohibited alienation of unauthorized construction. Besides that, the court held the mortgage agreement invalid in the light of the mentioned breach of the procedure for approval of a major transaction (Article 79 of the Federal Law on JSC).

Ruling by the court of appeal

Court of appeal upheld the bank's position and ruled that when making the mortgage agreement the latter did demonstrate due caution having requested a statement from shareholder register according to which the company’s CEO was its sole shareholder. Basing on the above the bank came to a justified conclusion that the agreement did not require approval. The court also noted that the above mortgage agreement went through a due diligence from the standpoint of validity in course of the state registration. Due to this, the court of appeal held that the bank was a bona fide pledgeholder who did not know and couldn’t have known that procedure for approval of a major transaction was breached.

Ruling by the cassation court

Circuit court upheld arguments of the court of first instance. It concluded that when making the agreement the bank demonstrated imprudence failing to request registration ledger information in which did not meet the contents of statements from shareholder register. The circuit court gave priority to this ledger as an evidence of shareholder composition. Basing on this the court of cassation held that the court of appeal was wrong saying that the bank did not know and shouldn't have known that procedure for approval of the agreement was breached. At the same time the court gave no legal opinion with regard to the conclusions of the court of first instance on invalidity of the agreement due to a breach of Article 222 of the Civil Code (on alienation of the unauthorized construction).

Ruling by the Supreme Court

Supreme Court reversed cassation ruling and upheld the ruling by the court of appeal arguing as follows:-

Burden of proof of the counterparty's bad faith. The court said that a transaction could not be held invalid if a party to it did not know and shouldn't have known that procedure for its approval had been breached. Otherwise a good faith counterparty would bear the risks of breaches of the legislation by the company. Supreme Court took into account that when making the agreement the bank did requested a statement from shareholder register which at that time the pledger was keeping on its own. The statement indicated that the company’s CEO was its sole shareholder, who signed the mortgage agreement therefore approving it. The pledger produced respective documents for mortgage registration. Basing on the above, the court stated that the bank, as a reasonable economic actor, shouldn't have had any doubts as to authenticity of documents produced by the company’s CEO. Circuit court was wrong in imposing the burden of proof with regard to its own good faith behaviour on the bank. It was the pledger who had to produce evidence of the bank's bad faith, thus confirming that the bank should have possessed other information of the pledger's shareholders. 

Pledge of unauthorized construction. Supreme Court stated that in accordance with Article 222 of the Civil Code declaring a building unauthorized construction may only take place when considering the issues of demolition or declaration of title to such unauthorized construction.

No such claims appeared before the court. Therefore, circumstances related to compliance with construction regulations in course of construction of the building at issue should not have been considered in the given case. The court emphasized that a record on the title of a bona fide pledgeholder may only be cancelled if a ruling on demolition of the building was rendered and enforced.

Abuse of right. The court stated that, as the owner of the building, the pledger should have had entire information on the building. It pledged the building, having signed the agreement and produced documents required for the state registration of encumbrance, and have not contested the transaction up until the moment when the proceedings on levying execution on the pledged assets were commenced. Referring to a breach of Article 222 of the Civil Code, the pledger has not taken any steps to cure the defects of the building by bringing it in the adequate shape. In the light of the above, the pledger’s claim is only aimed at lifting the encumbrance and preserving the building as such and the title record in the state register. Considering these facts, Supreme Court resolved that the pledger’s actions represent abuse of right (Article 10 of the Civil Code). And as such it is an independent ground for rejecting the claims.

Conclusions

We believe that Supreme Court's conclusions reached in the case at issue will affect the case law on contesting not only mortgage agreements but also other real estate related contracts, so as agreements documenting major transactions and interested party transactions.

 

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