Covid-19 has led to negative consequences for most sectors of the economy in many countries around the world and Russia is no exception. The introduction of a high alert regime in the spring of 2020 actually stopped or complicated the activities of most companies.
Considering this, it is important for creditors to control the financial and general economic situation of their large debtors during the coronavirus pandemic, in order to:
- Monitor their financial state;
- Collect information about the transactions performed; and
- File suits for the collection of large debts without waiting for the end of the moratorium on initiation of bankruptcy proceedings.
As for managers of companies and beneficiaries, who are under huge pressure of possible subsidiary liability due to current court practice, it could be beneficial to have documents confirming specific causes of financial difficulties of the company (independently or with the involvement of specialists), to prepare written plans for overcoming crisis situations, to coordinate actions with the shareholders, and to implement other measures securing their finances in case of company insolvency.
The more high-quality documents that confirm the good faith and reasonableness of management decisions (for both the debtor and creditors), the better chances that the manager and/or beneficiary has to protect their interests and to avoid subsidiary liability in the event of company bankruptcy.
Impact of Covid-19
As one of the support measures during the pandemic, the Russian government announced from April 4 2020, a moratorium on the initiation of bankruptcy proceedings for companies acting in the most affected industries (the moratorium was in effect until January 7 2021). The moratorium covered companies in particularly affected areas of activity, including tourism and transport, backbone organisations and strategic enterprises.
While the moratorium was imposed, the courts had to return applications for declaring the debtor bankrupt. Meanwhile, a number of restrictions were imposed on such debtors, the most important of which are as follows:
- The withdrawal of members and shareholders from the company, redemption by the debtor of placed shares were not allowed;
- The debtor’s obligations could not be terminated by offset, if this violates the order of satisfaction of creditors’ claims;
- Payment of dividends or income by shares, as well as distribution of profits between the participants of the debtor were not allowed;
- Penalties and other financial sanctions for non-fulfilment of monetary obligations and mandatory payments were not charged;
- Foreclosing on the pledged property both in a judicial and extrajudicial procedure was not allowed; and
- The enforcement proceedings were suspended.
Additionally, special rules were implemented for preventing the withdrawal of assets from companies that fell under the moratorium. Particularly, if within three months after the end of the moratorium, a bankruptcy case is initiated against the company, all its transactions related to the transfer of property and the assumption of obligations committed during the period of the moratorium will be declared null and void.
As practice has shown, on the one hand, the imposed moratorium helped maintain financial stability for companies most affected by the crisis. On the other hand, since no one cancelled debts on taxes, rent or salaries from companies, they continued to accumulate debts.
Russian bankruptcy law is going through a number of changes. The most significant changes were introduced on December 5 2019 by the Ministry of Economic Development. The introduced bill aimed to solve such problems of Russian bankruptcy such as the absence of working procedures for restoring the solvency of companies, the lack of independence of an arbitration manager from the debtor and creditors, and from being a sophisticated mechanism for selling assets of a bankrupt company at auction.
The bill proposes a list of measures, including abolishing three bankruptcy procedures (supervision, financial recovery and external management) and introducing rehabilitation (which has been successfully applied since 2015 in the bankruptcy of citizens) instead of them.
“The main issue to be kept in mind is that Russian insolvency law does not recognise foreign insolvency automatically."
Another important and controversial novelty is the new procedure for appointing an arbitration manager – randomly based on ranking. The key performance indicators for getting a higher ranking are creditors’ repayment rates and property sale prices. However, these factors are often beyond the control of arbitration managers, especially given that most debtors go into bankruptcy without assets. On the other hand, it is still unclear whether the competence, conscientiousness and other factors are deeply connected with the personality of an arbitration manager that will be included in factors influencing their rank position or not.
Another controversial and debated novel is the ability of arbitration managers to consider the validity of the creditor’s claims and to establish them in the debtor’s register outside of the court procedure. The possibility of ensuring independence and impartiality in their assessment of claims is highly questionable. In practice, it is possible to ‘duplicate’ the process of establishing creditors’ claims, when first they are considered by the arbitration manager, and then by the court based on the incoming statements about the unfoundedness of the decision of the arbitration manager.
The new edition of the bill No. 1172553-7, based on proposals of the Ministry of Economic Development, was presented in March 2020. It caused a lot of controversy among the state authorities and the legal community. Therefore, it is not clear whether it will be accepted by the parliament and what changes will be implemented on this way.
One of the most sensitive issues, which raises many disputes, is a broad interpretation of the ‘persons controlling the debtor’ for the purpose of subsidiary responsibility. According to the renewed chapter of the Federal Law on Insolvency (Bankruptcy) , any natural person or legal entity that could give orders to the debtor or could determine actions of the debtor in another way within three years before signs of the debtor’s insolvency occurred or later, up to the acceptance of the application on debtor’s insolvency by the court can be recognised as the person controlling the debtor. Therefore, a list of such persons is non-exhaustive and vague.
The latest court decisions on this matter raise huge concerns. In particular, courts impose subsidiary liability on general accountants and accounting outsourcing companies, spouses and children of managing director additionally to debtor’s management. There were attempts to impose subsidiary liability on legal firms, but it was unsuccessful.
Processes and procedures
Russian insolvency law provides for four procedures available for financially troubled debtors: supervision, financial rehabilitation, external management, and bankruptcy proceedings (liquidation). In practice, only two of these procedures are applied: supervision and bankruptcy proceedings.
The first procedure – supervision – helps to preserve the assets of the debtor. Supervision is introduced automatically after acceptance by a court of the first insolvency application (the exception: insolvency under the simplified procedure of the debtor in liquidation and insolvencies of some special entities).
It is important to note that at the stage of supervision, the relative independence of the company and its governing bodies maintains, despite the emplacement of the arbitration (insolvency) manager. At this stage, the insolvency manager analyses a debtor’s financial state, completes a creditors’ register, and holds the first creditors’ meeting.
The term of the supervision is seven months and after that, the first creditors’ meeting has to decide the next stage of the insolvency proceedings and agree it with the court.
Bankruptcy proceeding (liquidation)
The next frequently used procedure – the bankruptcy proceeding – aims to satisfy creditors’ claims through the sale of the debtor’s assets.
If the financial condition of the debtor has not improved, the court makes a decision on declaring the debtor bankrupt and initiating insolvency proceedings. The court appoints the insolvency manager (the same or different form the previous stage) to act until the insolvency proceeding is completed.
At this stage, the powers of the debtor’s general director and other managing bodies (with minor exceptions) are terminated. Managing bodies are vested with the insolvency manager.
The insolvency manager has exclusive rights over the disposal of the debtor’s assets during the execution of sale procedure. The term of execution sale is six months.
It is important to note, that the group of companies does not receive special treatment. On the contrary, the establishment of the affiliation of the debtor and the creditor causes the ‘subordination’ of the claims of such a creditor, which means a decrease in the priority of satisfaction of his claims.
As mentioned before, after being accepted by a court, the first insolvency application first stage of insolvency (supervision) automatically starts.
Introduction of supervision is connected with a wide range of consequences, such as:
- Creditors’ claims against the debtor and its assets are submitted only through the court supervising the insolvency proceedings; as a rule, no individual enforcement possible, accrual of financial penalties are terminated;
- Deadlines for the execution of obligations has arrived;
- The execution of court decisions is suspended;
- The restrictions on the disposal of the debtor’s property is removed; and
- Transactions aimed at transferring property from an entity to its participants are prohibited.
The introduction of the supervision is not a reason for the automatic termination of contracts, but it otherwise can be provided in conditions of the contract.
Sale of distressed debtor’s assets
Within the bankruptcy proceeding (liquidation), the insolvency manager offers the debtor’s assets for sale at two consecutive auctions. At the first auction, the sale price shall be approved by the meeting of creditors’ decision, while the sale price at the second auction has to be 10% lower than the initial sale price. If the second auction fails, the property is to be sold by way of a public offer with a gradual decrease in the price.
A feature of the sale of secured assets is that if the second auction fails, the secured creditor is entitled to appropriate the secured property at a value that is 10% lower than the offered sale price at the second auction.
The director (individual executive body, CEO) of the company in financial difficulty has to file the insolvency application with a court to initiate insolvency proceedings against the company they are managing if one of the insolvency criteria below is met:
- If claims against the debtor’s assets are enforced, the debtor will be unable to continue, or will be hard to enable its activity in continuing;
- The debtor passes a test – ‘inability to pay’: the debtor fails to perform its payment obligations when due as a result of the stress of money;
- The debtor passes a test – ‘insufficient assets’: the value of the debtor’s payment obligations exceed the value of its assets; or
- As a result of the stress of money, the debtor is unable to pay its labour obligations that are outstanding for more than three months.
If the director violates the obligation to file an application during the first month since the company satisfies the insolvency criteria, they can be held subsidiary liable for obligations of the debtor (company). It means that if the company is unable to pay debts to creditors at the expense of its assets, the creditors’ claims must be paid at the expense of the assets of the director.
Since the debtor’s assets are limited, creditors are interested to keep as few claims as possible included in the register of creditors’ claims.
The insolvency law grants creditors the following rights in this regard:
- To state demands for the exclusion of other creditors from the register;
- To provide the court with objections to the application of other creditors for their inclusion in the register of creditors’ claims; and
- To challenge the debtor’s transactions, on the basis of which the creditors want to include their claims in the register.
All of them are frequently used during the insolvency procedures.
Challenging transactions are one of the main mechanisms of protecting the interests of creditors, making it often used during insolvency proceedings in Russia. However, creditors cannot challenge every transaction. According to Russian legislation and court practice, creditors are able to challenge a transaction if:
- The transaction was aimed at asset stripping, and/or
- Transaction puts some creditors in a predominant position, and/or
- Transaction is obviously disadvantageous for the debtor.
Another important issue is the moment of entering into the transaction. It is possible to challenge the transaction if it was made up to three years ago (depending on the ground of the challenge) based on special insolvency provisions.
The insolvency law protects the interests of creditors whose claims appear after the initiation of insolvency proceedings (current payments). Current payments include monetary obligations, wage claims, and mandatory payments. There are also current requirements for payment for the goods supplied, services rendered and work performed, aimed at preserving the debtor’s working capacity, and the safety of his assets.
Current payments are priority claims because the moratorium on the satisfaction of the creditors’ claims does not apply to them. Moreover, current payments are satisfied earlier than another claims. There is a sequence of current payments: court expenses, remuneration of employees, and remuneration of labour of persons that engaged by the arbitration manager, maintenance payments, and other current payments.
Russian legislation provides for special insolvency regimes for certain industrial sectors. In particular: city-forming organisations, agricultural organisations, financial and credit institutions, strategic enterprises, monopolies, and developers. The insolvency procedure of all the above legal entities includes special conditions, which are due to the specifics of their activities.
For example, the insolvency procedure of financial and credit organisations is carried out by the Central Bank of the Russian Federation. Supervision, financial rehabilitation, external management and settlement agreements do not apply.
The insolvency procedure for individuals is significantly different. For example, starting in 2021, individuals can file applications of insolvency out-of-court.
Beyond common creditors, key stakeholders that could have a material impact on the outcome of a reorganisation is the Deposit Insurance Agency (DIA) and the Federal Tax Service. The DIA plays the role of an insolvency manager in a bank’s insolvency procedure. The Federal Tax Service has the extended creditors’ rights within insolvency and is also empowered to bring subjects to administrative responsibility for offences in the field of insolvency.
The main issue to be kept in mind is that Russian insolvency law does not recognise foreign insolvency automatically. As a rule, foreign court decision on insolvency of the debtor may be recognised in Russia in accordance with the international treaties or based on reciprocity. As Russia is not a member of any international treaty connected with cross-border bankruptcy proceedings, the recognition of foreign bankruptcy is a challenge. For example, in one case, the Russian court rejected the recognition of a Czech bankruptcy referring to a lack of reciprocity and all higher courts supported this decision.
“As the Russian proverb says: “Forewarned is forearmed”."
Consequently, a foreign insolvency manager may not have the opportunity to exercise his powers over the property located in Russia, and this may create subsequent problems.
Russian insolvency law does not provide a special provision for the opportunity of insolvency of a foreign company. Therefore, this issue is the matter of judicial discretion.
In the vast majority of cases, courts provide that only companies incorporated in Russia might be recognised bankrupt in Russia. The main reason for such a conclusion is the provision of conflict of law rules that provide that liquidation of legal entities shall be defined in accordance with the law of the place of incorporation. Another reason is that in accordance with the procedural rules, the claim for bankruptcy of the debtor should be filed in place of location of the debtor (for legal entities – a place of registration). The same approach will be applicable if a foreign legal entity has a branch or representative office registered in Russia. The approach will be different with regard to insolvency of the natural person, that can be found insolvent in accordance with Russian law based on the principle of sufficient ties.
Assistance to foreign proceedings
The recognition of foreign bankruptcy procedures by Russian courts depend on the type of court decision that is required to be recognised.
There is no unified approach to recognising foreign bankruptcy decisions. Paragraph 6, Article 1 of the Federal Law on Insolvency (Bankruptcy) dated October 26 2002, No. 127-FZ, provides that insolvency decisions of foreign state courts shall be recognised in accordance with international treaties of the Russian Federation, but in the absence of such treaties – on the basis of reciprocity.
The Russian Federation is not party of any international treaties related to foreign insolvency proceedings, therefore it is necessary to get recognition based on reciprocity. It is difficult to prove reciprocity in other states where the decision was delivered, therefore Russian state courts regularly refuse to enforce insolvency decisions.
It is impossible to enforce decisions based on the imposition of interim measures. The Supreme Arbtitrazh (commercial) Court stated that: “The rulings of foreign courts on the application of interim measures are not subject to recognition and enforcement on the territory of the Russian Federation, since they are not final judicial acts on the merits of the dispute issued in adversarial proceedings”.
Therefore, if there is a key asset of the debtor in Russia, and it is necessary get interim measures due to the asset, it would be more effective to open bankruptcy of the debtor in a Russian state court (if possible).
When assessing the efficiency of the measures implemented by the government to prevent massive insolvency, the results do seem unsuccessful. The number of bankruptcy cases have increased since the lifting of the moratorium on January 7 2021. This especially applies to small and medium-sized businesses. Related statistics confirm the concerns of experts who predicted that a moratorium on the initiation of bankruptcy proceedings without additional tax breaks, leasing payments breaks, or the subsiding of salary payments, will simply postpone the bankruptcies, but will not help to avoid them.
Looking into the future, there are many changes that businesses would like to see in insolvency regulations. The key point is for the introduction of effective procedures for the restructuring of debts with active participation of representatives of the debtor, shareholders and creditors, which will allow saving business activity of the debtor.
The main practical trends for the near future in the field of bankruptcy are:
- Mass involvement of the controlling persons of the debtor (for example, members/shareholders of the company, directors, chief accountants, members of the board of directors, etc.) to subsidiary liability, while directors will be held subsidiary liable in almost 100% of cases;
- Bypassing the ban on offsetting counterclaims by balancing. In fact, an offset is prohibited, and if the company offset claims in a pre-bankruptcy state, there are risks of challenging the transaction in the future. But for the creditor there is a way out – the balancing of counter claims, to which the courts are much more favourable. Recently, the Supreme Court has been gradually trying to soften the strict prohibition on offset by developing the theory of balancing, which is a way of calculating the final liability; and
- Active participation of banks in the search and foreclosure of assets abroad, bypassing the receiver in the Russian bankruptcy.
As the Russian proverb says: “Forewarned is forearmed”. The experience caused by Covid-19 shows that it is ultimately important to choose the contractors with due diligence, to document execution under the contracts in compliance with law and current practice, to make regular update of financial state of contractors, to make timely debts collecting and to catch the possibilities this new reality gives for growing of business.
Head of practice
T: +7 985 649 33 48
Alexandra Gerasimova us a head of practice at FBK Legal. She specialises in representation of Russian and foreign clients’ interests in court, in labour, commercial and corporate disputes and disputes in the areas of real estate and construction.
Alexandra has experience in providing support in bankruptcy engagements, and solution of legal issues arising in advisory engagements, with respect to labour, corporate, civil, currency legislation, and securities market regulations.
Alexandra is a graduate of Kutafin Moscow State Law Academy.
T: +7 985 200 71 20
Angelina Balakina is a lawyer at FBK Legal. She has experience in resolving legal issues in consulting and judicial projects pertaining to civil, corporate and employment law, including on international projects. She has expertise in civil, procedural, corporate, employment, IT and insolvency (bankruptcy) law.
Angelina is a graduate of Kutafin Moscow State Law Academy and of the Higher School of Economics.
T: +7 917 507 54 78
Anna Aktanaeva is a lawyer at FBK Legal. She represents the interests of large Russian and foreign companies in debt collection disputes (including dealership agreements, agency agreements and service agreements).
Anna also regularly works on disputes with government authorities, and on challenging transactions within the framework of bankruptcy procedures in courts of general jurisdiction and arbitration courts.
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