6 January 2005
The commercial laws of The Russian Federation. Part 11. Pledges and Mortgages

Pledges and Mortgages.

a. Property Subject to Pledge or Chattel Mortgage.

Pledge is regulated by the RF Civil Code (Art. 334-358) and other laws, such as the law On Pledge of 29 May 1992 No. 2872-1, the law On Hypothec (real property mortgage) of 16 July 1998 No. 102-FZ (as amended).

A property of value and/or economic rights may be pledged by the owner as a security for claims against himself or third parties. Certain categories of property and/or economic rights may not be pledged. This restriction is applicable particularly to (1) rights to items forbidden for transfer by private transactions (for instance, title to subsoil areas), (2) rights to assets exempt from execution (see further in section 17) and (3) economic rights (claims) of a personal nature (alimony, claims on health injury compensation and other rights that can not be assigned according to the law) and (4) specific types of property listed in certain laws (Art. 336 of the RF Civil Code). Specific regulation is applicable to certain types of pledges and mortgages depending on the type of collateral. This is true for mortgage of a real property, mortgage/pledge of transport means, mortgage of the goods in processing (the subject of the pledge of goods in turnover is not the property itself, but its value which may be changed proportionally to the value of the claim secured by pledge (Art. 357 of the RF Civil Code), mortgage/pledge of securities, and mortgage/pledge of currency.

Pledge of items in a pawn-shop is subject to special regulations. Only personal items may be used as a security. A license is required to operate pawn-shops (Regulation On Licensing of Pawn-Shops Activity, approved by the RF Government Regulation No. 1014 dated December 27, 2000, as amended).

Subsequent (subordinate) pledge is allowed where a pledge contract does not stipulate otherwise (Art. 342 of the RF Civil Code). Rights of all subsequent pledgees are ranked lower than rights of first pledgee. A pledgor shall inform all subsequent pledgees about all existing pledges of the property, nature and amounts of the claims secured by the pledge. In the absence of such notification, subsequent pledges are not automatically invalidated, but a pledgor bears responsibility to compensate all losses of the pledgee caused by the breach.

b. Creation of Pledge or Chattel Mortgage.

A pledge contract is valid if it includes:

• a pledged item (description of the property) and its value;

• a party which will have a possession of the pledged item; and

• nature, amount and time of performance of the claim secured by the pledge (Art. 339 of the RF Civil Code).

A pledge contract must be concluded in a written form and signed by the parties. An agreement for mortgage of real property must be certified by a notary. State registration of the agreement and of the right of pledge is required for pledge of rights to real property (Art. 339 of the RF Civil Code and art. 29 of the Federal Law On the State Registration of Rights to Real Property and Transactions with It No.122-FZ of 21 July 1997 (as amended).

A failure to follow these requirements on the form of the pledge agreement results in invalidity of the agreement.

There are two main types of interest in collateral: collateral with transfer of property to possession of the pledgee (pledge) and without such transfer (i.e. chattel mortgage). However, pledged property may be left with the pledgor under lock and seal of the pledgee (Art. 338 of the RF Civil Code). Transfer of goods in processing and real property to the pledgee is not allowed (Art. 338 of the RF Civil Code).

In case of pledge of documentary securities and negotiable instruments valuable papers (commercial papers) they are transferred to the pledgee or deposited with the notary public. Pledges of non-documentary securities are recorded by the registrar.

In case of chattel mortgage, security interest is perfected from the time when the contract of pledge comes into effect, unless otherwise provided for by the contract (Art. 341 of the RF Civil Code). A pledgor may use the pledged property and derive benefits from it, but bears the risk of accidental loss or damage to the pledged property, unless agreed otherwise.

In case of pledge with transfer of the pledged property to the possession of a pledgee, the pledge is perfected from the moment of transfer of the property, unless otherwise provided for by the contract (Art. 341 of the RF Civil Code). Pledgee is liable for the total or partial loss of or harm to an object of pledge transferred to it.

Both parties have a right to control conditions of storage and use of the pledged property. A party exercising possession of the pledged property is obliged, unless otherwise provided by the statute or contract:

• to insure the pledged property against the risk of loss or damage at the pledgor’s expense for the amount not less than the claim secured by the pledge;

• to provide safe storage of the property without causing any harm to it and to protect it from claims of the third parties; and

• to inform the other party about any danger of loss or damage to the pledged property (Art. 343 of the RF Civil Code).

Replacement of the pledged property is allowed upon the consent of the pledgee, unless otherwise provided by the contract or statute.

Transfer of goods in processing and real property to possession of the pledgee is not allowed (Art. 338 of the RF Civil Code).

Special requirements are provided by the law for goods in processing:

• a pledgor has the right to change the composition and the natural form of a pledged property (Art. 357 of the RF Civil Code). However, the cumulative value of the pledged goods must not be less than the value referred to in the pledge contract;

• the pledgor is required to maintain a register where the terms of the pledge agreement and all operations affecting the pledged property must be recorded; and

• in case of a breach of pledge contract by a pledgor, the pledgee has the right to halt the processing of such goods by way of putting its signs and seals onto them for so long as the breach has not been remedied (Art. 357 [4] of the RF Civil Code).

c. Foreclosure and Realization of Property Subject to Pledge or Chattel Mortgage.

Satisfaction of claims by getting ownership of a pledged item (collateral) is not possible in the Russian law. Under the Russian law the creditor may not simply assume ownership of collateral. A secured creditor has a right to compel sale of the pledged property and has a priority in distribution of proceeds from the sale of the pledged property. In all cases public sale of a collateral is mandatory.

Creditor’s claims are satisfied from the proceeds of the collateral in two steps procedure: foreclosure on the pledged property and sale of the pledged property.

Foreclosure on the pledged property is possible in case of improper performance or the failure to perform a duty (obligation) secured by the pledge/mortgage. A secured creditor has a right to compel sale of the pledged property and has a priority in distribution of proceeds from the sale of the pledged property. A court may refuse to foreclose on the collateral if a breach committed by the debtor is insignificant and the amount of secured claims is clearly disproportional to the value of the pledged property.

Foreclosure on the collateral can be either judicial or non-judicial. Non-judicial foreclosure on the mortgaged real property is allowed only by agreement made by secured creditor and mortgagor after the grounds for the foreclosure came into existence, certified by a notary.

For other property and/or economic rights non-judicial foreclosure is allowed in cases provided for by the pledge contract or subsequent agreement of the parties. By agreement, the parties may also set the initial price to be used for sale at a public auction.

Notwithstanding the above, non-judicial foreclosure in respect for any property and/or economic rights is strictly forbidden in cases where:

• a consent or permission of a third person or body was required for conclusion of the pledge agreement;

• a pledged property has significant cultural value for the society; or

• a pledgor/mortgagor is absent and its location cannot be discovered (Art. 349 of the RF Civil Code).

Realization (sale) of the pledged property can be performed only through a public auction in case of both judicial and non-judicial foreclosure. The secured claim is satisfied by proceeds from the sale of the pledged property. If proceeds from sale of the pledged property at a public auction are not sufficient to satisfy the claim in full, the creditor may recover the balance from other debtor’s property as non-secured creditor (unless otherwise provided by a pledge contract).

If the public auction fails, the creditor and pledgee/mortgagee may agree to dispose private sale of the pledged property and to set-off claims secured by the pledge/mortgage against the purchase price.

If the second public auction fails, the pledgee has an option to buy a title to the pledged property at the price not lower than 90 per cent of the initial selling price at the public auction.

d. Termination of Pledge or Chattel Mortgage

A pledge is terminated automatically when:

• a duty (obligation) secured by the pledge is terminated;

• a collateral is destroyed and pledgor does not restore or replace it or the secured right is terminated;

• a collateral property was not sold at the second public auction and the pledge (beneficiary) failed to exercise an option to buy the property within one month;

• a collateral property is sold at a public auction; or

• a duty (obligation) secured by a collateral is assigned to a third party (unless otherwise provided for by the contract between the pledgor and the secured creditor) (Art. 352 of the RF Civil Code).

A pledge with transfer of property into possession of a creditor (pledgee) may be terminated upon the demand of the pledgor if the creditor violates its obligations to insure the pledged property and/or to take necessary measures for safekeeping of the property and/or to notify the pledgor of the danger of loss or damage.

The pledge is terminated automatically when the pledged property is seized from the pledgor on the ground that the owner of this property is another person or as a sanction for the commission of a crime or other violation or pursuant to a requisition or nationalization order. In these cases pledgee has the right to demand early performance of an obligation secured by the pledge. In case another property is given in exchange for seized property, such property becomes a collateral. If the compensation is paid for such property, secured creditor has the priority right to satisfy its claim against the amounts of compensation due to the pledgor.

Where the title to collateral property and/or rights is transferred to another person, including a transfer by the way of universal legal succession, security interest in collateral remains effective.

e. Specific regulation for mortgage of real property (hypothec)

Specific rules for regulation of mortgage of land plots, enterprises, buildings structures, residential and other real property are established by the Federal Law On Hypothec (real property mortgage) of 16 July 1998 No. 102-FZ (as amended). The general rules on pledge set forth in the RF Civil Code shall be applicable to the mortgage of real estate unless otherwise provided for by the above-mentioned law On Hypothec (art.334 of the RF Civil Code).

i. Real property subject to mortgage

The real property mortgage might arise on the ground of the agreement or by virtue of a law. The owner whose ownership for the real property was registered under the established procedure may mortgage the following types of real property:
a. land plots;
b. enterprises and buildings and other real property used for entrepreneurs activities;
c. residential houses, apartments and the parts to thereof, consisting of one or several separate rooms;
d. country houses (“dacha”), garages, and other household constructions;
e. aircrafts, vessels, and space ships (Art. 5 of the federal law On Hypothec).

A building under construction (other unfinished real property) can be mortgaged as well. The mortgage for the building, construction, or uncompleted real property can be established only together with the mortgage for the underlying land plot (or part of the land plot).

A part of the real property that cannot be separated in practice without change of its function (the indivisible real property) cannot be an isolated subject of mortgage.

ii. Conclusion of Mortgage Agreement

A mortgage agreement is concluded in conformity with the general principles of the RF Civil Code and the law On Hypothec.

A mortgage agreement shall include the subject of the mortgage (its name, location, and description sufficient for its identification), its value, the nature, amount and time for performance of the claim, secured by the mortgage. In case the secured claim, based on the contract, its parties, date and place of its signing shall be mentioned in the mortgage agreement.

A mortgage agreement shall include the type of the owner’s right to the collateral and the name of the state body registering real estate rights, that registered this right of the mortgagor.

A mortgage agreement shall be deemed concluded and comes into effect starting its state registration. The encumbrance of the real property pledged under the mortgage agreement rises from the moment of the conclusion of the latter. The right of the mortgagee (mortgage right) is perfected upon the enrollment of the notice on mortgage into the State Register of the rights for real estate. The rights of the mortgagee for the mortgaged property are not subject to the state registration (Art. 10 of the law Оn Hypothec).

iii. Land plots mortgage

There are certain specifics regarding mortgage of land plots in cases:

a. mortgage of state or municipal land plots (Art. 63 of the law On Hypothec);
b. mortgage by lifetime inheritable possessor (Art. 267 [2] of the RF Civil Code);
c. the size of land pots is less than minimal land plot size established by regulations of the Sub-units (regions) of the Russian Federation.

The mortgage of a land plot does not extend to buildings and constrictions, including uncompleted, located on such land plot unless a mortgage agreement states otherwise (Art. 64 of the law On Hypothec).

A copy of a land plot drawing (map of boundaries) must be attached to a land plot mortgage agreement (Art. 67 of the law On Hypothec).

iv. Mortgage of enterprises (some specifications)

Under article 340 of the RF Civil Code the entire business can be subject to a mortgage. In this case all movable assets (equipment, raw materials, products, movable constructions etc) and immovable property (buildings, immovable constructions, etc) belonging to it, including rights of claim and exclusive rights, serve as a security unless otherwise provided by a contract. Enterprise mortgage is only available to secure monetary obligations with a maturity period not shorter than one year after conclusion of the mortgage agreement (Art. 71 [2] of the law On Hypothec). In addition, the amount of obligation secured by mortgage in this case shall not be less than a half of the total value of the mortgaged enterprise (Art. 71 [1] of the law On Hypothec).

v. Mortgage of residential houses and apartments

Residential individual houses and apartments in multi-apartment buildings as well as privately owned buildings may be subject to mortgage. Mortgage of state and municipal residential individual and multi-apartment buildings and apartments is not allowed (Art. 74 the law On Hypothec).

Foreclosure on a mortgaged house or on apartment and public sale thereof terminate a right of a pledgor and its family members to use such residences. In this case a pledgor and its family have to vacate the house/apartment (Art. 78 the law On Hypothec).

vi. Mortgage Certificate

A mortgage certificate certifies the rights of the mortgagee under the secured obligation and under the mortgage agreement. The mortgage certificate is a registered security, conferring the following rights upon its owner/holder:

a. the right to receive performance under the monetary obligation, secured by the mortgage, without presenting any other evidence of existence of such obligation;
b. the mortgage right to the property encumbered with the hypothec (mortgage) (Art.12 of the law On Hypothec).

A mortgage certificate cannot be issued for mortgage of enterprises, land plots intended for agricultural needs, forests and lease rights thereto, as well as if the amount of a monetary obligation secured by mortgage is not defined at the conclusion of the mortgage agreement and such agreement does not contain terms allowing to determine such amount (Art. 13 of the law On Hypothec).

The state registering body issues a mortgage certificate to a primary holder upon the state registration of the mortgage. Any lawful owner of a mortgage certificate may require such state registering body to enroll its name into the Uniform State Register of rights to real estate.

vii. Hypothec securities

The RF Federal Law On Hypothec Securities dated 11 November 2003 regulates issue and turnover of so-called “hypothec securities” with the exception of mortgage certificates. There are two types of hypothec securities:
a. debt certificates backed by the mortgage;
b. mortgage certificates of participation.

Debt certificates backed by the mortgage can be issued by special hypothec agents and financial institutions (banks, etc). The amount of obligations secured by mortgage, and constituting mortgage coverage of these securities may not be less than 80 % of their nominal value.

Only profit-making organizations, having special licenses (to manage business activity of unit investment funds, investment funds, non-state pension funds) can issue mortgage certificates of participation.

RF state bodies and the Bank of Russia regulate not only hypothec securities issue, but also business activity of hypothec agents and mortgage covering managers.