The Degree of Protection of Creditor Interests in Russia: Up or Down?

20.07.2009

New amendments to Russian insolvency (bankruptcy) legislation may protect some “good” creditors while making other participants of the local debt restructuring market more nervous in the shadow of the new wave of bankruptcies.

The economic crisis continues to dictate new terms for doing business in Russia and most other countries. Meanwhile, the Russian government is trying to keep pace with the changing market environment elsewhere and is setting obstacles to prevent distressed debtors from chaotically managing their debts and also selectively favoring creditors, who are more agile and bolder. In addition to political governance and virtual direct intervention in some of the most significant and emblematic cases involving locomotives of the Russian economy, a substantial number of power-wielding efforts are being implemented in the legislative sector. In this area, the Russian authorities are taking strategic measures to prevent unjust and sometimes harmful corporate and financial arrangements that enable parties to skim off the cream and leave somebody else to “enjoy” the subsequent insolvency proceedings.

On April 28, 2009, the President of the Russian Federation signed into law new amendments [1] to the Federal Law “On Insolvency (Bankruptcy)” (hereinafter referred to as the “Insolvency Law”), which should be considered by everyone participating in the market for distressed assets and industries, including, but not limited to, shareholders, directors and other members of management and particularly creditors of companies that suffer from financial troubles.

At first sight, most amendments appear to reflect pro-creditor concepts that were extensively introduced to previous packages of amendments [2] adopted just before the New Year. After digging a little deeper, however, you discover that it is highly likely that you will be forced to take part in bankruptcy procedure to be considered as creditor acting in good faith. In most cases this means a serious delay in getting your money back.

To begin, it should be noted that these new amendments de facto introduce two new bankruptcy indicators. They establish the following criteria for identifying a potential debtor as the “insufficiency of property” and “non-solvency”. Insufficiency of property means that the aggregate value of monetary obligations (under “civil” transactions) and mandatory payments (taxes and duties) exceeds the aggregate value of the debtor’s assets. This would appear to be similar to the “balance-sheet test” in English law, whereas “non-solvency” (inability to pay) refers to a debtor’s default on payments under monetary obligations or mandatory payments attributable to capital inadequacy and is reminiscent of the “cash-flow test” in English law. It is extremely important to note that capital inadequacy is assumed in the event of such failure unless the contrary can be proved.

One the one hand, such an assumption will prevent the management of significant Russian companies from implementing their favorite debt-management game called “pray for payment” where a payment schedule is established on the basis of personal preferences and only occasionally adheres to the terms and conditions of a specific agreement. At the same time, however, these provisions refer to the obligation of the general director (or other executive officer) to file for bankruptcy within one month [3]. They disturbingly narrow the scope for possible options that could be applied to rule out the company’s insolvency, such as debt restructuring or corporate restructuring.

More importantly, the new provisions, “overtly” provide new grounds for challenging debtor’s transactions as voidable by an insolvency officer (an external administrator or bankruptcy receiver) on his own initiative or further to a decision of a creditors meeting. It should be noted here that the previous version of the Insolvency Law already contained some provisions allowing for challenging transactions executed by a debtor before an application for bankruptcy had been accepted by the court or at later stages of the actual insolvency. However, the terms and conditions and procedure of transactions challenging have not been specifically stipulated. This lapse will be eliminated through the enforcement and itemization of such categories as suspicious “undervalue” transactions, suspicious transactions damaging the creditors’ proprietary interests and preferential transactions.

Suspicious Transactions

A transaction is deemed suspicious and “undervalue” when performed within one year before the bankruptcy (acceptance of the bankruptcy application by the court) and provides for an unequal consideration by the debtor in favor of the counterparty (the transaction does not comply with comparable market conditions and the prices or consideration provided by the debtor exceed materially the value received under this transaction).

The “undervalue” transaction indicator would appear close to the “market price” concept stipulated by the Russian Tax Code [4]. However, if there are no clarifications on “comparable market conditions” and indications of materiality (where the difference between the provided and received item should be deemed “material”), as well as methods for determining the price, we assume that the practical methods for contesting such a transaction will be ambiguous and that specific claims will depend to a large extent on the discretion of the insolvency officer.

A transaction is deemed damaging (also referred to as “suspicious”) if performed three years before the bankruptcy with the intention of damaging the creditors’ proprietary interests (by decreasing the volume of the debtor’s property and/or increasing the size of the debtor’s obligations).

The concept of preferential transactions that had existed in the Russian Insolvency Law was amended by provisions that clarify the terms for allocating the preference (the transaction was performed to secure the existing obligations of one of the creditors or resulted in a change in the priority order of creditors, etc.)Under the amendments, if the counterparty actually knew that the debtor had insufficient assets or was unable to pay (non-solvent), any transaction performed six months before a court’s acceptance of a bankruptcy application may also be challenged.

As a result, to all intents and appearances transactions that appeared to a potential debtor and even more to a potential creditor as usual in the normal course of business are now fraught with material risks [5]. These risks are increased substantially in connection with the fact that the rules of transactions challenging apply explicitly to deals and all actions and operations that lead to the fulfillment of obligations and duties that arise in accordance with civil, labor, matrimonial, tax, and customs legislation and all actions conducted in the execution of a court decision, legal acts or the acts of other state authorities.

If a specific transaction is deemed voidable by the court on the above grounds, a special form of restitution is applied. All the assets provided by a debtor shall be returned to the debtor (or equivalent cash compensation is granted) and included in the bankruptcy assets. Only then may creditors under such transactions be granted the right to file an appropriate claim with the debtor. This claim could be settled and paid in accordance with specially established priority rules, depending on the type of deal that has been challenged. In all cases, however, the priority of such a creditor will be qualified at best as third class (unsecured obligations).

Other key amendments concern implementation of the notion of “a debtor’s controlling party” considered to be the person authorized to give mandatory instructions to the debtor or capable of determining in some other form the debtor’s actions within two years before the court acceptance of the bankruptcy application. For this purpose the Insolvency Law stipulates the secondary (vicarious) liability of a debtor’s controlling party. Such liability is assumed to exist (a debtor’s controlling party has to prove that it was acting reasonably and in good faith). The amendments also establish the liability of the general director of a company for missing accounting documents and for the misstatement of data in the accounts. Increasing the liability of company management constitutes another attempt by Russia’s lawmakers to prevent violations of the insolvency rules in the current harsh economic climate, in particular for management already overtly involved in schemes to transfer valuable assets from one company in a holding to another company, leaving all the obligations with the “abandoned” one.

To summarize, it should be noted that the newly declared “pro-creditor” amendments aim to prevent asset stripping within a company on the verge of insolvency and in the present context to expand bankruptcy assets through the filing of claims against third parties. This could potentially provide additional resources that should be used to fulfill the debtor’s obligations before its bankruptcy creditors. At the same time, however, the provisions related to challenging transactions could constitute an extremely powerful tool in the hands of an insolvency officer that could particularly be leveraged for goals that are far from innocent or honest. That is why the new legal opportunities could have an opposing effect on creditor interests. Creditors should think at least twice before trying to enforce obligations and/or securities against their debtors. And it is clear that it could occasionally appear far easier for managers to institute bankruptcy proceedings than to look for possible arrangements and assume such hair-raising subsidiary liability.

Recommendations

Insolvency procedures performed to wind-up debtor’s assets would appear to offer far less advantages for everyone involved than many other possible work-outs or arrangements such as debt restructuring (apart from some slick operators). In view of the most recent legislative changes, we recommend caution when considering how to structure and formalize mentioned arrangements. Choosing to wait a bit longer rather than seeking to implement measures immediately will enable you to avoid finding yourself queuing up in a big line for refunds with little hope of success. There is a risk that the adoption of aggression now could be punished.

If bankruptcy seems unavoidable, it is vital that you secure as much control over the process as possible. If you are a creditor, think about how to recover claims and make friends with other creditors. If you are a debtor’s shareholder/manager, do not consider that the only solution is to run away and give up. Insolvency does not always mean liquidation. Insolvency can be leveraged (although this does not happen frequently) as a debt restructuring option and also as a peaceful solution.

You must be extremely careful when contracting with a company on the verge of bankruptcy. Even if the deal is closed by the time of the counterparty’s bankruptcy, there is a risk that the creditors of the counterparty could subsequently invalidate your contract and reclaim everything that you received under it.



[1] Federal Law No. 73-FZ dated 28 April 2009 “On Amendments to Certain Legal Acts of the Russian Federation” was officially published on 5 May 2009 and enters into force within 30 days of the official publication date.

[2]  Federal Law No. 296-FZ dated 30 December 2008 “On Amendments to the Federal Law “On Insolvency (Bankruptcy)” .

[3] According to Clause 2, Article 10 of the Insolvency Law, violation of filing requirements will lead to secondary liability of the party liable for this violation.

[4]  Clause 4, Article 40 of the Russian Tax Code.

[5] There is only one exemption to this rule: a transaction conducted in the course of the usual business of the debtor if the value of the assets that were transferred does not exceed one percent of the total value of the assets, However, this exception is not applicable in a “damaging” transaction.

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