Stopping a business share: When, how and why it occurs

What is a share pledge and when is it used?

A pledge of a business share is the creation of a pledge over a share in a limited liability company (s.r.o.). It serves primarily as a form of security for a debt – most often a loan taken out either by the shareholder himself or by the company. This protects the creditor in case the debt is not repaid.

Only shares that are transferable can be pledged, under the same conditions as for their transfer.

A pledge of a business share starts with a properly drafted contract

A pledge is created by a pledge agreement. It must be in writing and should be accompanied by certified signatures. By law (Section 1314 of the Civil Code), the share cannot be surrendered as a thing in the possession of the pledgee, which is why this form is required.

The contract must clearly specify:

• which person is the pledgee and who is the pledgee,
• which share is pledged (the share of a particular shareholder in a particular Ltd.),
• what the secured debt is (e.g. a loan, an obligation under a credit agreement).

In some cases, the pledge agreement may be supplemented by a prohibition on alienation and encumbrance of the share (i.e., the owner may not transfer the share to another [alienate] or further encumber it with another pledge without the consent of the creditor). This is also entered in the commercial register.

What to look out for in the memorandum of association when pledging a shareholding

The terms and conditions for pledging a share are governed by the memorandum of association or articles of association. These may state that the approval of the general meeting is required to pledge the share, that pledging is completely excluded and that other specific restrictions apply.

If the agreement is silent, the default rule applies – the share can be pledged, but under conditions similar to a transfer. The exception is single-member LLCs, where all these restrictions are irrelevant (under the Corporations Act).

Without registration in the register, the pledge of a shareholding does not apply

The contract alone is not sufficient. In fact, the right to pledge the share only arises upon registration in the Commercial Register, with so-called constitutive effect. The application for registration can be submitted either electronically via the justice.cz portal with an electronic signature, via a data box without the need for an electronic signature, or by a document with officially certified signatures.

The application may be filed by the pledgee, the pledgor (i.e. the shareholder whose share is being pledged) or the limited liability company itself.

The application must clearly state the identification of the shareholder and his share, the designation of the pledgee, the specification of the secured obligation and the amount of the share, together with the necessary contractual details. The original or a certified copy of the pledge agreement or, where applicable, the agreement prohibiting the alienation or encumbrance of the share must be attached to the application.

What rights and obligations does the pledge of a business share entail?

Pledging a share in a limited liability company (s.r.o.) is a legal step that gives the pledgee certain options to secure its claim. However, these options do not automatically arise by signing the pledge agreement itself. The pledge must be notified to the company in order for it to have any legal effect at all. Without such notification, the pledgee has no rights against the company. In addition, if the shareholders’ meeting’s approval of the pledge is required under the articles of association, this approval must be attached to the documentation, otherwise the pledge will not come into existence.

Once these formal steps have been completed, the pledgee has the right to exercise certain rights attached to the shareholding, in particular:

• Voting rights: if the parties have expressly agreed to this in the pledge agreement, the pledgee may exercise the voting rights attached to the business share. This allows the pledgee to influence the running of the company – for example, to vote at the general meeting on important decisions such as amending the articles of association, approving the financial statements or distributing profits.
• Right to a share of profits: the pledgee is only entitled to a dividend or other benefit from the pledge when the debtor fails to do what it should have done – that is, when the debt matures and is not paid. So if someone guarantees with shares and the debt is not paid, the creditor is then also entitled to dividends on those shares. Again, this right must be agreed in the pledge agreement. This is one of the ways in which a creditor can secure partial satisfaction of his claim without having to sell the shares.
• Disposal of the share in the event of non-payment of the debt: If the debtor (the owner of the share) fails to meet his debts, the pledgee has the right to proceed to realise the pledge. Most often, this means selling the share at a public auction or in another agreed manner and using the proceeds to pay his claim. This process is subject to certain rules, for example, the pledgee must exercise caution and ensure that the share is not sold significantly below its value. You can read more about the actual process of realising a pledge below.

What are the implications for the shareholder? The owner of a business share temporarily loses some of his or her rights associated with the share. In particular, he or she loses the ability to decide on the running of the company to the extent that these rights have been transferred to the pledgee. At the same time, he loses a share in the profits if that right is also subject to a pledge. This situation lasts until the debtor has discharged his debt and the pledge is extinguished or until the share is sold.

How is the pledge of a business share implemented?

If the debtor fails to fulfil his debt, the pledgee has the right to proceed to the so-called realisation of the pledge – i.e. to turn the pledged business share into money and to use the money to pay the claim. But how does this work?

Unlike real estate, a share in an LLC is usually not sold at a court or bailiff auction. The pledgee usually has two options: either sell the share in a voluntary auction or find a buyer and transfer the share by direct agreement. However, it must always proceed in such a way that the share is sold at the normal market price. Otherwise, the debtor could defend himself and challenge the whole process.

Before proceeding with the sale, however, the lender must comply with several legal steps. First of all , it must notify the debtor that it is proceeding to realise the pledge. At the same time, it must clearly quantify exactly how much the debtor owes – including principal, interest and any penalties. Only then can it choose the method of sale.

And what are the risks? First of all, a business share in a particular company may be virtually unsaleable – for example, if the company is indebted, unprofitable or has a bad reputation. Or simply no one is interested in the share. A creditor can easily find itself in a situation where, although it has the right to sell the share, its value is so low that it does not even come close to covering the debt. Therefore, it is always important to thoroughly check not only the debtor himself but also the economic health of the company in which the share is pledged before entering into a pledge.

What to look out for when pledging a business share?

It is easy to make a number of mistakes when pledging a business interest that can complicate or even invalidate the whole process. Some of the most common ones include a poorly drafted or too vague pledge agreement, as well as failing to look at the memorandum of association, which may restrict the pledge or make it subject to the approval of the general meeting.

Forgetting to file a proposal for registration of the pledge in the commercial register, or if the proposal is incorrectly filled in or lacks mandatory annexes, is also a very common problem. And here you need to be really careful, because if the registration court rejects the proposal, you cannot simply correct it and resubmit it. You have to start the whole process from the beginning. That is why it is definitely worthwhile to turn to a specialist, for example a lawyer who is well versed in this issue and can set up the whole process correctly. We will be happy to help you with the pledge of your business interest.

_tip:

A share in a single-member LLC can be pledged without limitation – no approval of the general meeting is required.

Summary

Pledging a shareholding in an LLC is a common way of securing a debt, typically a loan, where a shareholder pledges his or her shareholding as collateral to a creditor. A share can be pledged if it is transferable, subject to the same conditions that apply to its transfer. The key step is a properly drafted written pledge agreement with certified signatures, which must clearly state who the pledgor is, the pledgor, what share is being pledged and what debt is being secured. The pledge only becomes effective upon registration in the commercial register, and if the articles of association provide for restrictions (for example, the need for the consent of the general meeting), these must be complied with. Once all the formalities have been completed, the pledgee acquires the rights attached to the share, such as a share in the profits or voting rights, if this is agreed in the contract. If the debtor fails to fulfil the debt, the creditor can sell the share – most often by voluntary auction or outright sale, but must always ensure that the share is sold at market price. The risk is that the share may be unsaleable or lose value, especially if the company is in debt. In addition, the process of pledging a share is fraught with formal pitfalls – the most common mistakes include a poorly drafted agreement, ignoring restrictions in the memorandum of association, or errors in the application for registration, which cannot simply be corrected but must be re-filed.