Pledge on investment participation units in a fund | In Principle

Sometimes, in financing transactions, for various reasons related to the structure of the particular transaction and the commercial arrangements of the parties, atypical assets are offered as collateral for receivables of the financing party. In such situations, the parties need to think about how to select legal instruments to implement commercial collateral arrangements. Investment participation units in a fund are an interesting asset due to the specific statutory regulations.

A participation unit is nothing more than the legal title entitling the holder to participate in the assets of an open-ended investment fund or specialised open-ended investment fund. A participation unit is one of the forms of title for participation in investment funds. A unit represents a property right of the particular fund participant.

Typically, to offer participation units as collateral, the parties need to consider a registered, pledge, a financial pledge, or a civil pledge.

Legal classification of participation unit for pledge

First we must consider what participation units in a fund are legally, and whether they can be pledged. Pursuant to Art. 83(2) of the Polish Investment Funds Act (Act on Investment Funds and Management of Alternative Investment Funds of 27 May 2004), a participation unit cannot be transferred by a participant to third parties. However, it is subject to inheritance. Thus, lawmakers expressly prohibited the sale of units to third parties. Certainly, for this reason, it will not be possible to establish security on participation units in the form of an assignment of security rights.

In theory, it might seem that pledging participation units is prohibited. However, an adjacent provision, the first sentence of Art. 83(1) of the Investment Funds Act, provides a clear exception, stating that a participation unit may be subject to encumbrance in the form of a pledge. According to principles of statutory interpretation, exceptions should not be interpreted broadly. Therefore, it should be concluded that actually a pledge is the only possible encumbrance on participation units.

These provisions of the Investment Funds Act also correspond with the general provisions on what assets can be pledged:

• The Civil Code provides that an ordinary pledge may be established on “rights,” and a participation unit is a property right of the fund participant.
• The Act on Certain Forms of Financial Security of 2 April 2004 provides that a financial pledge may be established on financial instruments, in particular titles of participation in collective investment institutions, i.e. including participation units.
• The Registered Pledge Act (Act on Registered Pledges and the Pledge Register of 6 December 1996) provides that a registered pledge may also be established on rights attached to financial instruments which are not securities within the meaning of the Act on Trading in Financial Instruments of 29 July 2005, and thus on participation units.

Thus it is apparent that the Polish regulations permit establishment of an ordinary pledge, a financial pledge, or a registered pledge on participation units in an investment fund.

Formal conditions for establishment and effectiveness of a pledge on participation units

To create a pledge requires a pledge agreement. The agreement must be signed by:

• The pledgor, i.e. the person holding a specified number of participation units to be pledged
• The creditor, i.e. pledgee (in the case of a registered pledge, the construction of a pledge administrator acting on behalf of a group of creditors may also be used).

The pledge agreement can be made and executed in ordinary written form; only in the case of a civil pledge will an authenticated dated form be required. The pledgor should also produce and attach to the agreement, for example, an extract from the register of participants in the investment fund confirming that the pledgor actually holds a certain number of participation units.

In the case of a registered pledge, a constitutive condition for the pledge to be effective is also entry in the pledge register maintained by the competent court. The enforcement provisions of the Registered Pledge Act require that the subject of the pledge be described in the pledge register in accordance with the catalogue of descriptions of the subject of a registered pledge. Therefore, the parties need to determine which category covers the units. This is made more difficult as the catalogue does not expressly provide for such a separate category. In the author’s view, the units should be classified and recorded in the pledge register under item D2 (other relative right). From the author’s experience, the pledge courts will not dispute that classification.

In addition to these formal conditions for a registered pledge, another formal condition applicable to all pledges and required by the Investment Funds Act is recording of the pledge in the register of fund participants. Indeed, creation of a pledge on participation units becomes effective upon making the appropriate entry in the fund’s register of participants at the request of the pledgor or pledgee, upon presentation of the pledge agreement to the fund. The register of participants is maintained by the open-ended investment fund, and in principle it should contain all the information regarding the participants and the participation units they hold, as well as references to entry of a pledge. Thus, unlike a pledge on many other assets, the provisions expressly require entry in the register by the fund, i.e. a real transaction, in order for the pledge to be effective in securing the participation units. Unfortunately, mere notice to the fund of a pledge is not sufficient grounds for effectiveness of the pledge. Additionally, a formal element required by the law is presentation of the pledge agreement to the fund. In the author’s opinion, the provisions do not require presentation of the original of the agreement, and a simple copy, or a copy certified by a notary or a party’s attorney who is an adwokat or attorney-at-law, should suffice. Also, in the author’s opinion, the fund should not examine the pledge agreement, but can only check whether the agreement contains the elements required by law and was concluded in the proper form. Whether an investment fund has the right to investigate the due representation of the parties to a pledge agreement and request, for example, notarised copies of the signatories’ powers of attorney with proof of authority, is debatable, because the law does not govern such technical details.

Enforcement of pledges on participation units

Finally, we must discuss a vital issue for any security, i.e. enforcement. The great advantage of registered pledges and financial pledges is the possibility of extrajudicial enforcement carried out by the creditor itself. Nevertheless, with respect to enforcement, when it comes to pledges on participation units, as a more specific law (lex specialis), the Investment Funds Act introduces far-reaching limitations and modifications. In principle, the act gives primacy to judicial enforcement, indicating in the second sentence of Art. 83(4) that satisfaction of the pledgee from the pledged asset takes place only as a result of repurchase of the participation units by the fund upon a request submitted in enforcement proceedings. In principle, the repurchase will be made in accordance with the valuation of the participation units through the investment fund as of the date of the bailiff’s request in the enforcement proceedings. Thus, all methods of extrajudicial enforcement typical for registered pledges and financial pledges, consisting in assuming ownership of the pledged asset or selling it through a public auction conducted by a notary or bailiff (in the case of a registered pledge), are excluded.

The Investment Funds Act provides only one exception and possibility of the pledgee to seek satisfaction outside of judicial enforcement. Namely, the pledgee’s satisfaction does not require enforcement proceedings if satisfaction is based on a pledge agreement established in accordance with the Act on Certain Forms of Financial Security. In such case, the fund makes a payment to the account of the pledgee of the amount due for repurchase of the participation units. It is a quick and simple method of enforcement allowing the creditor to bypass time-consuming, costly and complicated court enforcement proceedings, and requires only the submission of a repurchase request to the fund along with a statement confirming the maturity of the secured debt. Nevertheless, such an option is only possible for a financial pledge, which can only be established in favour of an entity meeting the criteria of a financial institution as defined in the EU’s Capital Requirements Regulation.

Also, to strengthen the pledgee’s position and ensure that the pledge is real and enforceable, the Investment Funds Act provides that prior to the maturity date of the receivable secured by the pledge, the pledgor cannot, without the pledgee’s consent, make a demand to the fund to repurchase the pledged units. This “perfects” the pledge and means it cannot be extinguished by the pledgor’s disloyal actions. On the other hand, if the receivable secured by a pledge has become due and payable, the pledgor may request the fund to repurchase the pledged participation units, but the proceeds from repurchase by the fund may be paid to the pledgor only upon presentation of the creditor’s acknowledgement that the receivable secured by the pledge has expired. This allows the pledgor to cash in the participation units if the secured and maturing receivable has been satisfied, for example, as a result of enforcement by the pledgee against other collateral or as a result of general enforcement by the bailiff.

To sum up, a pledge on fund participation units is an interesting form of collateral whose statutory regulation significantly deviates from the standard pledge provisions of the Civil Code, the Act on Certain Forms of Financial Security, and the Registered Pledge Act. Therefore, when less-typical assets are offered as collateral, especially securities or other financial instruments, in addition to the standard pledge regulations, the parties must thoroughly analyse the statutes regulating the particular type of securities or financial instruments, as they often contain special provisions concerning the collateral significantly differing from the standard solutions.

Mateusz Tusznio, adwokat, Banking & Project Finance practice, Wardyński & Partners