A bill introducing amendments to the Russian Civil Code, including Section II governing property law, has been under preparation since 2008, and has been the subject of public discussion since November 2010. The discussion has been almost exclusively limited to the amendments to Section I of the Civil Code governing legal entities and corporate governance. It was feared that a number of proposed amendments to Section I would complicate substantially the business environment in Russia, already suffering from over-regulation and excessive administrative barriers.
These amendments included a complete reshuffle of corporate forms, a drastic increase in the minimum charter capital required to set up a legal entity, replacement of the general compliance check with a substantive review of constituent documents by registration authorities, the introduction of supervisory boards in all joint stock-companies in addition to a board of directors, and the new mandatory requirement for the presence of a public notary at shareholder meetings.
In comparison, the amendments to Section II of the Civil Code have been the object of far less public scrutiny, and yet are of no less import. The proposed amendments would modify the fundamentals of property law in Russia to such a degree that all property owners and developers would be affected.
Despite vocal dissent by some of the key ministries of the Russian government, the controversial bill is likely to be introduced to the State Duma in the autumn legislative session at President Medvedev’s insistence, and is expected to be adopted fairly quickly. Given that the President himself is pushing for comprehensive civil law reform, and is encouraging the State Duma to take the matter in hand and resolve all outstanding issues by the normal legislative process, it is possible that a new Civil Code in Russia introducing yet another set of drastic legislative changes like those over past 15 to 20 years may be promulgated in 2012, and enacted soon thereafter, perhaps with some short transition period.
Legislative background
Section II has been part of the Russian Civil Code since its introduction in 1994, but its effective date was deferred time and again due to the fact that it was drafted to operate in conjunction with the Land Code which was not itself in existence until late 2001.
However, when the Land Code was finally enacted, it was somewhat at odds with Section II of the Civil Code as it introduced a two-tier property title system consisting of ownership and leasehold of land, whereas the Civil Code provided for other types of title, including the “permanent use right” – a quasi-title granted only over state or municipal land with limited functionality for commercial entities. Owners of buildings located on state or municipal land (first and foremost, privatised industrial enterprises) were required to either buy the land underlying their facilities or to lease it by 2004, when their interim permanent use right was due to expire.
However, large Russian corporates, all of whom had privatised vast facilities often exceeding the needs of their more modern operations, were faced with the threat of considerable capital outlay in order to buy property which they already considered their own. They therefore successfully lobbied for a series of prolongations of the deadline, in the meantime only paying land tax, and the strict two-tier concept was thus left in limbo.
On July 18 2008, President Medvedev instructed his Council for codification and improvement of civil legislation to develop a set of amendments to the Civil Code, which took the form of a completely new draft Civil Code. Draft amendments were made available to the public in November 2010. The chapter governing title to land, intended to fill in the blanks and straighten out the convoluted maze which used to be Russian property law, is so detailed that it is likely to have precedence over the respective provisions of the Land Code and possibly also of the Water Code insofar as land adjacent to water reservoirs is concerned, both of which would normally rank higher than the more general rules of the Civil Code, being industry-specific.
Permanent use right: from obsolescent to cornerstone
The amendments would strengthen the role of the former quasi-title to land misleadingly named permanent use right. This title will apply primarily (but not exclusively) to land used for agriculture and other natural uses (forestry, fishery, protected areas, mining, and so on). The permanent user would also be entitled to exercise land owner’s authority over the underlying subsoil. Thus, the reformed permanent use right may, in conjunction with the new concept of mining servitude, provide a solution to the longstanding issue regarding what title a subsoil user should have over the land containing his mining allotment.
The term of permanent use is meant to be indefinite, or in any case no less than 50 years. This precise requirement for long-term land use is a novel concept in its own right. Previously the maximum allowable lease term was deemed to be 49 years, though this was never enshrined in any law, much less in the Civil Code. Under the amended Civil Code, the user would be expected to make payments to the owner of the land, reviewable every 10 years, which, in case of state or municipal land, could be capped at rate of land tax.
Alternatively, land use payments could be made in kind, in the form of a share of agricultural or mining produce, which would allow the re-introduction of production sharing agreements into the Russian mining industry, previously dabbled with in the 1990s but subsequently dismissed by the state as disadvantageous to public interests.
In comparison to the current regime, where a so-called permanent use right was granted by the state to initial users as a non-transferable right which must subsequently be converted into leasehold or ownership, the revamped rights will become fully transferable titles over both state or private land. The permanent user will be allowed to sell, lease or mortgage its land rights, though limitations may be imposed by the title instrument.
Importantly, permanent use – rather than leasehold – will become the primary title granted to developers for construction purposes: only permanent users will be able to obtain a development right, another novel entitlement.
Development rights: building follows land
A development right, as a discrete entitlement allowing a person to build on land owned by another, has never previously existed in Russian law. When this entirely new legal device is enacted, the structuring and documentation of development projects will never be the same again.
In accordance with prevailing market practice, developers must first secure a short-term leasehold over the land, make sure that the land category and permitted use allow design and construction works, get the detailed design approved and obtain a construction permit, then renew or extend the lease to cover the construction term; finally, when the building is put into operation and title recorded in the property register, the developer can opt for either a long-term lease (usually 25 or 49 years) or ownership of the land underlying his building.
In the case of residential development, particularly apartment blocks, it is the individual end-occupiers who may collectively apply for long-term joint leasehold or joint ownership of the underlying land, which, in practice, happens very rarely because the occupiers have little to gain from busying themselves with the intricacies of the administrative processes.
Under the new regime, leasehold will have no part to play in documenting development projects. The developer will first be required to obtain a permanent use right, and may then conclude a development agreement with the ultimate owner of the land (usually the state or the municipality as land suitable for greenfield development is still almost invariably state owned). The agreement will specify what the developer is allowed to build and how long he has to do so, as well as setting out the entitlement term, which should be between 50 and 100 years. The development fee will be freely negotiable and reviewable once every 10 years. When the entitlement term expires, the building will either become the land owner’s property, or must be demolished.
Introduction of development rights fundamentally changes the balance between ownership of the building and ownership of the underlying land in favour of the latter. To date, the characteristic feature of Russian property law was the maxim “land follows building”, enshrined in article 271 of the Civil Code and articles 35 and 36 of the Land Code. If the amendments take effect, the building owner will still have statutory land use rights under what is now article 297.1 of the new draft Civil Code; however, as more and more development entitlements come into existence, the balance will shift in the direction of “building follows land”, akin to the position in most civil law and common law jurisdictions.
Needless to say, these complicated procedures would not apply to land owners wishing to build on their land: ownership will remain the most comprehensive title to land, allowing any kind of land use, including development, given compliance with zoning and planning rules.
Servitudes: ancient concept put to?practical use
Servitudes, being limited entitlements of a property owner over neighbouring properties, are inherited from Roman tradition and are hardly novel to Russian property law. However, they are very rarely used, most likely due to a very short and vague and yet all-encompassing regulation: article 274 of the Civil Code allows a property owner to claim any servitude deemed “indispensable” to his rightful needs. In practice, servitudes are rarely formally granted even in clear-cut cases such as passage or access to mains and utilities.
Under the amended Civil Code there will be five clearly defined types of servitude: rights of passage and access; construction; drainage; utility and pipelines; and mining. The latter is of particular importance: a subsoil user will now be able to claim limited entitlement over the overlying land plot in order to build and access deep mines and bore wells. An equivalent entitlement may be achievable under the existing regime but, due to the lack of clarity, this has not been the Russian mining industry’s preference.
A mining venture, in the best case scenario, will opt for a lease, or, in very rare cases, full ownership over the relevant overlying land, both options involving time-consuming and convoluted multi-stage administrative processes and high overheads. For these reasons, it is not infrequent for subsoil users to have no proper title to the overlying land, leaving the mines and wells legally exposed.
Though mining servitudes would come with a price tag, as land entitlements are not intended to be free or cheap, if the process for their establishment was sufficiently easy and streamlined (which appears to be the intention of the bill) the mining industry would surely embrace them in order to reconcile its land affairs.
Open-pit mining, tailing and sludge pits, and dumps requiring vast spaces would require a more comprehensive title such as permanent use.
Leasehold and mortgage: connection severed
Leasehold title to land will continue to exist. Its relevance will be greatly reduced, however, as it will lose its strong connection with development rights and mortgage. For example, the current rules require that a building may only be mortgaged together with title to the underlying land, which is not always possible in various legitimate situations, including where the owner of a building holds the underlying land under a permanent use right which is not mortgageable, or where a short-term lease expires and is in the process of renewal, which invariably takes an inordinate amount of time.
This situation has caused lending banks concern lest the validity of their collateral be successfully challenged on these formal grounds, and has given rise to a number of disputes, some reaching Russia’s highest review venue for commercial matters. the Presidium of the High Court of Arbitration. In recent rulings the Presidium held that in some cases a mortgage would remain valid even when the underlying lease agreement had been subsequently annulled. However, and as is generally the case in civil law jurisdictions, Russian court decisions are not technically binding (although decisions of the higher courts enjoy strong persuasive authority) and cannot therefore be relied upon as a conclusive interpretation of the law.
Under the draft amendments, however, the mortgage of a building becomes a “limited property right” with respect to the mortgaged asset, and, when the building and the land do not belong to the same owner, as would inevitably be the case when private buildings stand on state-owned land (which remains the predominant situation in Russia) the owner will be able to mortgage the buildings without the rights to the underlying land plot.
Independent and subordinated mortgage
In addition to unwinding the numerous problems with which Russian courts have struggled for years with varying success, regarding the mortgaging of buildings with imperfect land titles, or the further complexity when these buildings are multi-owned, the new bill will introduce two important concepts: the subordination of mortgages and the independent mortgage.
Under the current regime, a pre-existing mortgage will always rank higher than a subsequent one, so in order to alter the seniority, often necessary in refinancing and restructuring deals, the pre-existing mortgage would need to be lifted and de-registered, much to the discomfort of the original creditor. The newly amended Civil Code would allow the mortgagees to agree to change the seniority of their respective mortgages. Thus a pre-existing mortgage could rank below or pari passu with a subsequent mortgage in accordance with its terms, facilitating the structuring of project finance deals involving both debt and equity finance.
A mortgage as an accessory obligation is rigidly tied to a particular defined principal obligation, which is normally a debt under a precisely referenced loan agreement, whose terms are painstakingly reproduced in the mortgage agreement. However, an independent mortgagee (by definition a financial institution) would be able to freely determine the obligation which it means to collateralise. An independent mortgage or a mortgage-backed security could be recorded in the property register regardless of whether the secured obligation already exists.
The mortgage-backed security must, however, stipulate the maximum amount recoverable, and the term of the independent mortgage could not exceed 30 years regardless of whether it was securitised. Foreclosure of properties subject to an independent mortgage would also be a lot easier: the mortgagor will not be allowed to invoke the terms, validity or defects of the principal obligation as a defence against foreclosure. Furthermore, the restrictions allowing a mortgagor to resist foreclosure on account of the mortgagee’s claims being insignificant or disproportionate to the value of the mortgaged property will not apply to independent mortgages.
Thus, independent mortgages and mortgage-backed securities would be likely to appeal to lenders and help kick-start the stagnant mortgage security market, which is kept above the water line mostly through the efforts of the State Residential Mortgage Agency.
Forward sales legalised
Another new entitlement introduced by the draft bill is the “right to purchase immovable property”, which would in effect lead to fully enforceable forward sale agreements effective for up to 10 years.
As well as existing properties, the underlying assets could be mortgage or development rights, or, importantly, properties that are going to be built in the future. The prevailing uncertainty as to how to document forward sales transactions in the absence of any clear statutory guidance would finally be resolved after plaguing the real estate market and hindering property investment for years.
This new entitlement would be fully transferable and recordable in the property register. It is envisaged that buyout rights under property leases and participatory construction agreements will also be premised under this entitlement, though the latter implies the need for further changes to another much discussed piece of legislation: Federal Law No 214 on Participatory Construction.
Notaries re-introduced
Most of the novel concepts which would be introduced to the property section of the Civil Code are, though little short of revolutionary, relatively uncontroversial by nature as they are clearly intended to help resolve existing legal issues and make property transactions and development more transparent and predictable. However, making all property conveyancing subject to notarial certification in addition to the registration requirements may be a big drawback in the Russian context (though usual in continental law systems).
When private property conveyancing rules were first established in the 1990s, notarial certification of mortgages and other property transactions was obligatory. The law was changed and the requirement for mandatory notarial certification abolished between 1998 and 2004, when the property register became fully operational and was deemed to adequately fulfil the public record element intrinsic to property law. This reform was much welcomed by the public, who considered notarial certification to be an unnecessary hurdle with no added value at a time when high tariffs made property conveyancing unacceptably expensive.
Furthermore, most notaries had minimal legal qualifications and their integrity was not always above question. Insufficient professional indemnity insurance added insult to injury. When the reforms took effect and this role of the notaries was abolished, the number of fraudulent conveyances was rumoured to have considerably diminished.
Though there has been talk of the reform of the notarial profession, concurrent with the civil reform, making all property transactions subject to expensive and intrusive notarial certification will be a highly unpopular measure.
However, every cloud has a silver lining: it is intended that notaries will take charge of payment settlements and state registration formalities, thereby creating a substitute for escrow accounts, otherwise non-existent in Russia. Transferring the sale money to the notary, who is responsible for procuring state registration and delivering the property certificate to the new owner, will help resolve an issue central to virtually all title transfers in Russia: the issue of where the money is held while the property register takes its time to record new title.
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About the author
Margarita Slavina is a Russian-qualified lawyer specialising in corporate and real estate. She advises clients on M&A, joint ventures and general corporate matters and has developed a particular expertise in the real estate sector. She advises on financing of construction projects, acquisitions and disposals of properties and real estate vehicles and structuring of joint development projects related to retail, office and industrial properties.
Margarita graduated from the international law department of the Moscow State Institute for International Relations. She joined the firm in 2007 after spending several years with other international law firms. |
Contact information
Margarita Slavina
Herbert Smith CIS LLP
10 Ulitsa Nikolskaya
Moscow 109012
Russia
t: +7 495 363 6500
f: +7 495 363 6501
w: www.herbertsmith.com |