Forfeitable pledges are not fair. When will creditors learn their lesson?

Despite contrary appearances, gaining possession of a debtor’s property by exercising a pledge is an endeavour doomed to failure.

A pledge as a form of security naturally strengthens a creditor’s position. It has a preventative influence on debtors, forcing them to repay their debts duly and on time under the threat of their assets being liquidated if not. The payment function of the pledge also enables the creditor whose receivables are not paid duly and in a timely fashion to seek satisfaction by gaining access to the cash proceeds from the exercise of the pledge. Applicable law, however, prohibits the pledgee from satisfying its receivable by simply gaining possession over the pledged property. An agreement on such a “forfeitable” pledge is absolutely invalid, i.e. ex tunc.

Although this is nothing new, creditors can be found from time to time who forget about this rule or who simply try to get away with such a lucrative deal. The law, however, must be known and respected. Otherwise it may happen that, instead of a safely secured receivable, creditors will get neither their money nor the pledged property.

The Constitutional Court added its opinion on this issue relatively recently. Last year it considered the case of a debtor who contractually provided real property to a creditor in the amount of CZK 60 million as a form of security over a debt in the amount of CZK 7 million. If the due amount was not paid, the creditor was to become the owner of the property. When this happened and the creditor claimed its title to the property, the debtor filed an application with the court for protection.

The Court of First Instance correctly found that this was in principle a case of a forfeitable pledge. According to the court, the covenant was moreover – in view of the fact that the value of the receivable and the value of the pledge were grossly disproportionate – in conflict with business ethics. The court found the relevant agreement invalid ex tunc. The creditor gradually filed all possible appeals, but always unsuccessfully. Even its objection that such solution gives rise to an unequal position was not accepted as the courts left both the money and the real property with the debtor.

As this case showed, the issue of forfeitable pledges is clear in the mind of the court. Given the illegal nature of the conduct, cases like this one will always end like this, regardless of the passing of time and the amicable proposals of both parties. The current legal regulation may be considered correct, since, in addition to circumventing the purpose of the pledge, a forfeitable pledge, as the case mentioned above shows, is often in conflict with business ethics.

Not only is an agreement on a forfeitable pledge itself illegal, but any contract enabling the pledgee to handle the pledge as if it were its own or to sell it or otherwise turn it into cash to satisfy the secured receivable is also illegal. Trying one’s luck is not worthwhile, quite the opposite. And what about your pledge?