How is protection against third parties achieved when transferring or pledging shares?

7 Jun 2021

Pledging of shares and transfer of shares

For a transfer of shares or a pledge of shares to be valid in the event of the seller’s or pledgor’s bankruptcy, the transfer or pledge must be protected against third parties (sakrättsligt skydd). An agreement on the transfer or pledge is therefore not sufficient; under Swedish law, an additional step is required for the buyer or pledgee to be able to assert their contractual rights in the event of the counterparty’s bankruptcy.

This perfection of the legal act must be completed when the seller or pledgor is declared bankrupt; otherwise, the buyer or pledgee only receives an unsecured claim in the bankruptcy, often with very limited value.

The question of how a transfer of shares becomes protected against third parties is answered differently depending on whether share certificates have been issued or not. Furthermore, for CSD-registered companies (avstämningsbolag), i.e., companies where the shares are registered with a central securities depository (usually Euroclear), different rules apply than for non-CSD companies (kupongbolag), i.e., companies where the shares are not registered with a central securities depository. The vast majority of limited companies in Sweden are non-CSD companies. In CSD-registered companies, share certificates are not issued. In non-CSD companies, share certificates have traditionally been issued, but in many such companies today, no share certificates are issued.

The conditions for achieving protection against third parties in these different situations are described below. I consistently write here about the transfer of shares, but corresponding rules apply regarding pledges.

Case 1 – Non-CSD companies with share certificates

According to Section 22, first paragraph of the Promissory Notes Act, to which Chapter 3, Section 6 of the Companies Act refers, an acquirer of negotiable promissory notes has achieved protection against the transferor’s creditors when the acquirer has “gained possession of the document.” This provision applies correspondingly to share certificates. The provision expresses the so-called principle of tradition (traditionsprincipen), which means that a change of possession must have occurred (and the seller must have lost control over the property) for the buyer to be protected in the event of the seller’s bankruptcy. In practice, this provision means that the buyer must have gained possession of the share certificates to which the transfer relates in order to demand that the purchase remain valid in the seller’s bankruptcy.

There is, however, an exception. In cases where the share certificates are not with the seller but in the possession of a third party when they are sold, tradition can be replaced by denunciation (denuntiation), i.e., a notice to the third party about the sale. The notice, which can be provided by either the buyer or the seller, serves as a substitute for tradition. If it concerns a pledge, it should be emphasized that if the pledgee wishes to carry out the denunciation themselves, they must present a written document to the third party showing that a pledge has been promised.

Case 2 – Non-CSD companies without share certificates

The question of protection against third parties when purchasing shares in a non-CSD company without share certificates is not regulated by law. Nor has the question been assessed by the Supreme Court. There is therefore no clear answer as to how a buyer should obtain protection against third parties for their purchase of shares in these cases. This is despite the fact that such transfers of shares are, of course, very common. Legal literature advocates that protection against third parties in such cases arises through denunciation to the company in which the shares are issued. In practice, a buyer should therefore ensure that the company’s board is notified of their purchase, but it is not clear whether this, if the matter were put to the test, is sufficient for the buyer to be protected against third parties. Those who are anxious not to be exposed to any risk in their capacity as a buyer therefore often choose to demand that share certificates be issued in connection with the completion of the transfer (thereafter it becomes Case 1 as described above).

Case 3 – CSD-registered companies

Protection against third parties in CSD-registered shares is obtained according to the Financial Instruments Trading Act, put briefly and simply, through notification to the account-holding institution followed by registration or, in the event that the shares are registered with a nominee (whose internal records show who the shares belong to), through notification to the party registered as the nominee for the share.

Concluding comment

When a company has sold or pledged shares and is subsequently declared bankrupt, it is of crucial importance for the buyer or pledgee that the respective legal step for protection against third parties, as described above, is completed when the bankruptcy is decided. Otherwise, the purchase or pledge is not fully valid in the bankruptcy, and the buyer or pledgee only receives an unsecured claim in the bankruptcy.

I and my colleagues at Carler have extensive experience in insolvency-related business law. If you would like more information or assistance related to the legal issues concerning third-party protection touched upon in this article, or any other business law matter, you are welcome to contact me or one of my colleagues.