Securing Cotton

How do you obtain security interest on cotton stock warehoused in Uzbekistan? Igor Sidelnikov* explores methods as well as legal options in the event of a default.

Cotton is a good example of a strategic commodity used in international trade between private entities. However, various legal impediments regarding the nature of the commodity, similar to those of countries with over-centralised command economies, impede Uzbekistan from achieving finance and developing mutually beneficial trade relationships. Oil, gold, uranium, or any other strictly controlled resource, are also difficult to establish.

This article sets out a general summary of certain Uzbek law aspects with respect to security over movable property, including cotton stored in Uzbek territory. The analysis is based on the general context of Uzbek law, the Civil Code of the Republic of Uzbekistan, effective 1 March 1997 (the Civil Code), the Law of the Republic of Uzbekistan ‘On Pledge’ dated 9 December 1992, as amended and restated on 1 May 1998 (the ‘Law on Pledge’), and the Law of the Republic of Uzbekistan ‘On Valuation Activity’ dated 19 August 1999 (the ‘Law on Valuation Activity’).

Creating a security interest

The applicable form of security for stored cotton is a pledge, something that has always been difficult to create clearly in Uzbekistan. Pursuant to Article 3 of the Law on Pledge, a pledge arises by virtue of a contract or on the basis of a law. Article 264 of the Civil Code sets forth a similar provision. Accordingly, a pledge agreement between a pledgor and pledgee will suffice to create a security interest.

In accordance with Article 5 of the Law on Pledge and Article 267 of the Civil Code, any property, including things and property rights (or demands), may be the subject of a pledge. The exceptions are things that have been withdrawn from turnover, demands inextricably connected with the person of the creditor (in particular, demands concerning compensation for harm caused to life or health, alimony), and other demands where an assignment to another person has been prohibited by law. Cotton and its products are widely used in Uzbekistan, are not withdrawn from turnover, and, therefore, may be used as a pledge.

Three types of pledge may be used in a given situation. The first is a pawn when the pledged property is transferred from the pledgor to the custody of the pledgee. The disadvantage of this is that the pledgee is liable for the full or partial loss of, or damage to, the subject of pledge transferred to him. This is the case unless it is proved that he is relieved of responsibility in accordance with the legislation (Article 34 of the Law on Pledge and Article 275 of the Civil Law).

The second is a pledge where the subject is left with the pledgor but under the lock and seal of the pledgee (Article 36 of the Law on Pledge and Article 269 of the Civil Code). The subject of the pledge may also be left with the pledgor with the imposition of marks testifying to the pledge (firm pledge). This type is convenient for the pledgee, since it relieves the pledgee of liability for the safety of the pledged property. However, there is a corresponding increase in the risk of loss of the pledged property due to the actions of the pledgor. Nevertheless, the pledgee has the right to check – documents and factual availability – the pledge property, its amount, state and conditions of storage (Article 19 of the Law on Pledge).

The third type is a pledge of goods in turnover under which goods are left with the pledgor and the pledgor is granted the right to change the composition and natural form of the pledged property (goods reserves, raw materials, finished products, and the like) on the condition that their total value does not become less than that specified in the pledge agreement (Article 289 of the Civil Code and Article 42 of the Law on Pledge). If the pledgor violates the conditions of the pledge, the pledgee has the right, by placing his marks and seals on the pledged goods, to suspend operations with them until the violation is eliminated.

Let’s imagine a case where the cotton is in storage on Uzbek territory, presumably in the name and under the control of the pledgor. In this instance, the second type of pledge would seem to be appropriate. The pledge agreement should require that the cotton be locked up and under the control of the pledgee; it should require the marking of the cotton and the granting to the pledgee of the right of inspection.

It should be noted that Article 12 of the Law on Pledge provides that the pledgor or the pledgee, depending upon which of them has possession of the pledged property, shall, if otherwise not provided for by law and the contract, insure the pledged property for its full value against the risks of loss or damage; and if the full value of the pledged property exceeds the size of the secured demand – for the value not less than the size of the demand. Therefore, in a pledge agreement, it is suggested the burden of this insurance should be transferred to the pledgor. Further, Article 12 of the Law on Pledge provides that the pledgee is the beneficiary under the insurance of the pledged property to the extent of the secured demand.

There is no requirement to register a pledge of moveable property, and, accordingly, no system in Uzbekistan for giving public notice of the existence of a pledge of such property.

Pledgor

Article 8 of the Law on Pledge and Article 266 of the Civil Code provides that the owner thereof may be the pledgor of a thing and the person to whom the pledged right belongs may be the pledgor of a right. These provisions state clearly that only the owner of property may pledge it in favour of another person. In the case of cotton, it is unclear which organisation owns cotton in Uzbekistan, thereby enabling it to act as a pledgor. Here we need to distinguish between legal ownership and operational possession. The reasons for such conclusion are the following.

At the moment, Uzbekistan still uses the old Soviet method of state planning for cotton production, with only minor changes. The entire process of cotton production involves the participation of many state organisations. At the beginning of each year, the Uzbek Association of Cotton Industry or ‘Khlopkoprom’, which is an agent for the state, enters into agricultural procurement contracts with agricultural enterprises and farmers (hereafter the ‘cotton producers’). The government – through the Fund For Settlement of Agricultural Products Purchased for State Needs – under the Uzbek ministry of finance, finances cotton producers by making advance payments of up to 50% of the contract price. Cotton producers deliver produced cotton to gins [a machine that separates the seeds from raw cotton fibres] belonging to Khlopkoprom. Cotton fibre is exported in a centralised manner through state foreign trade companies. The final settlement between cotton producers and Khlopkoprom is carried out after the latter receives export proceeds, part of which will be distributed to gins and the above-mentioned fund.

Under this process, it is difficult to identify which entity owns the produced cotton. It is unclear whether the producers own the cotton or whether Khlopkoprom independently controls the produced cotton, or indeed if the ministry of finance decides its fate, since it finances its production. However, taking into account the fact that cotton is a strategic product for the Uzbek economy and its production is entirely financed by the state, it is our understanding that the cotton industry as a whole belongs to the state and the state enjoys the exclusive ownership right over produced cotton and the proceeds of its sale. It might well be that the financing of cotton production by the Uzbek government is carried out by using loans from foreign creditors secured by a future harvest of cotton produced in Uzbekistan. Therefore, it is our understanding that a decision by the Uzbek government is necessary to obtain a security interest in cotton. In our view, a decree by Uzbek cabinet ministers will be sufficient in this regard.

Valuation of pledged property

According to Article 11 of the Law on Valuation Activity, valuation is mandatory when a transaction involves objects belonging fully or partially to the state, including where the object of valuation is the subject of a pledge. A valuer licensed by the Uzbek state property committee must perform the valuation. However, to the best of our knowledge, it can be a very difficult task in practice, ie, it may not be possible to find such a valuer or the latter may not be capable of doing it. Therefore, this problem should be borne in mind when concluding a pledge agreement. In order to additionally comply with Article 11, it might be possible to obtain an independent valuation from an auditor, but this will not be a valuer licensed by the state property committee. Another semi-legal possibility is to obtain a valuation from a valuer approved by the state property committee with official confirmation by this committee for the results of such a valuation.

Perfection of security

Pursuant to Article 9 of the Law on Pledge and Article 270 of the Civil Code, the right of pledge arises from the moment of conclusion of the pledge agreement, or, if the agreement is subject to notarial certification, from the moment of notarial certification; and in the event of obligatory registration of the agreement – from the moment of the registration thereof. Neither the Law on Pledge nor the Civil Code state that a pledge of movable property, particularly of goods, is subject to notarial certification. Therefore, it is our understanding that a pledge of cotton does not require notarisation for the validity and enforceability as of the conclusion of a pledge agreement. Please note that, if cotton in accordance with a pledge agreement must be situated with the pledgee, the right of pledge arises at the moment of the transfer to him of the cotton, and if such transfer was brought about before the conclusion of the pledge agreement, from the moment of its conclusion.

Enforcement

In accordance with Article 27 of the Law on Pledge and Article 279 of the Civil Code, a pledgee may enforce its rights over the property pledged to it if the pledgor fails to perform or improperly performs the obligations secured by the pledge. However, both articles provide that execution against the pledged property may be refused if the debtor’s failure to meet its obligations is minor and the amount of the pledgee’s claim resulting from such failure is not commensurate with the value of the pledged property subject to foreclosure.

Uzbek law provides that pledged property may be foreclosed upon, either by a court order or by means of self-help. Pursuant to Article 27 of the Law on Pledge and Article 280 of the Civil Code, a court order must be obtained to enforce a pledge of movable property, unless otherwise agreed between a pledge and a pledgor. As it is not clear from the law what kind of ‘agreement’ it should be, our interpretation is that a separate agreement between a pledgee and a pledgor made in simple written form (ie, without notarial certification) would be required (in addition to the existing pledge agreement) for them to be able to foreclose the pledged property without recourse to the court. However, Article 27 of the Law on Pledge and Article 280 of the Civil Code also provide that enforcement by means of self-help is not permitted if: (i) the consent or permission of a third person or authority is required to enter into the pledge agreement; (ii) the pledged property has historical, artistic or other cultural value; or (iii) the pledgor is missing and is impossible to locate.

It is unclear whether the prohibition on self-help set out in Article 27 of the Law on Pledge and Article 280 of the Civil Code applies if the pledgor has obtained the required authority consents from the Uzbek government. Although there is no direct authority on this point, our interpretation of Uzbek law is that that the pledgee should be able to exercise self-help remedies if it has obtained the consent of the Uzbek government permitting the pledge of cotton.

Although the pledgee could exercise self-help rights under Uzbek law, Uzbek security law is untested and undeveloped. Therefore, the pledgee may want to consider exercising its security right with respect to the pledged cotton by filing an action with an Uzbek court and obtaining a court order enforcing its security rights.

According to Article 28 and 30 of the Law on Pledge, the disposal of pledged property may occur by two methods: (i) public sale of the pledged property or (ii) the assignment of property rights to the pledgee if the subject of the pledge was property rights. Uzbek law does not provide any detailed procedure on how to conduct public sales. It is our understanding that the general practice in Uzbekistan is to carry out the disposal of pledged property in accordance with the method provided for in the pledge agreement to the extent permitted by Uzbek law. As such, the pledge agreement should contain appropriate details for disposal of the pledged property.

It is worth noting that, according to Article 28 of the Law on Pledge and Article 281 of the Civil Code, the court may, upon the reasonable request of the pledgor, postpone disposal of the pledged property for up to one year. The rights and obligations of the pledgor and pledgee are not affected during the period of such postponement and the debtor is not released from the requirement to reimburse the creditor for any losses incurred during the postponement.

In accordance with these two articles, if the initial public sale is unsuccessful, the pledgee would be entitled (in agreement with the pledgor) to acquire the pledged cotton before a second public offering and to set-off the price of the pledged cotton against the amount secured by the pledge. If the pledgee chooses not to acquire the pledged cotton at this time, it should offer the cotton for sale at a second public sale. If this second sale is unsuccessful, the pledgee may retain the pledged cotton, in which case the declared value of such cotton (and the corresponding decrease in the pledgor’s debt) may not be less than 90% of the initial sale price. Pursuant to Article 29 of the Law on Pledge and Article 281 of the Civil Code, a pledge agreement is terminated by operation of law if the pledgee does not exercise its rights to retain the pledged property within one month of publication of a notice announcing the failure to sell the pledged property at the second public sale. Also, if the amount received from the sale of the pledged property exceeds the pledgee’s claim, the pledgee is required to pay the difference to the pledgor.

Pursuant to Article 50 of Law on Pledge, when concluding a pledge agreement or by virtue of a future agreement, parties are entitled to conduct the public sale of the pledged property in countries other than Uzbekistan. However, in doing so, the requirements of Uzbek customs laws must be observed. This effectively bans the export of such property without governmental support. Article 50 also provides that the laws of the country where the sale takes place define the procedure of sale of the pledged property.

Choice of law

According to Article 49 of the Law on Pledge, the form of the pledge agreement, rights and obligations of the parties, the consequences of non-performance or improper performance of the pledge agreement, the assignment of demands and transfer of debt are governed by the law of the country chosen in an agreement by the parties unless otherwise provided for by a law. However, in the absence of agreement of the parties concerning the law subject to application to the pledge agreement, the law of the country where the pledgor is founded, has a place of residence, or principal place of activity, shall be applied to the pledge agreement. Please also note that, pursuant to Article 49 of the Law on Pledge, apart from the governing law chosen by the parties, the law of the country where the enforcement of a pledge is sought shall be taken into account. This means that even if the parties decide to choose the law of a third country to govern a pledge of cotton situated in Uzbekistan, Uzbek law should be observed with respect to the methods and procedure of enforcement of the pledge when the enforcement is sought in Uzbekistan.

*Igor Sidelnikov is currently director for Triton Hydrocarbons, (Sydney, Australia), which conducts oil & gas business in the Middle East, former Soviet Union and North Africa. Prior to this, he was legal counsel for Lukoil Saudi Arabia Energy – an upstream joint venture between Saudi Aramco and Lukoil Overseas. He is also consultant for the European Bank for Reconstruction and Development on RM/corporate recovery in Uzbekistan. In addition, Sidelnikov spent three years as managing attorney in the Tashkent office of international law firm Denton Wilde Sapte, where he was responsible for the local management and supervision of Uzbek law.

Sidelnikov was born in Minsk, Belarus. He has an MSc in Political Economy of Transition in Europe from the London School of Economics, UK, an LLM for foreign lawyers from John Marshall Law School, Chicago, US, and is a graduate of the Belarusian State University Law School. He speaks Russian, English, Belarusian, French and some Polish.