The end of Russian business as we know it

-- 4 May 2009 --
TEXT: E. Andreeva
PHOTO: Peter Galbraith - Fotolia.com.

Banks are at the heart of the Russian anti-crisis program. The Kremlin believes that they can be restrained from destroying insolvent companies and forcing the bankrupts into liquidation or selling their key assets.

Changes to insolvency laws adopted in December 2008 aimed to achieve this by strengthening the position of unsecured creditors and of a bankrupt.

If formal bankruptcy has become a shield - not a sword - it must operate both ways. If creditors are asked to wait, they must be assured that while they wait someone else will not be eating their lunch.

The law #73-FZ of April 28, 2009 'On changes to certain legislative acts of the Russian Federation', which comes into effect on June 5, 2009, helps creditors to trace the assets of an insolvent company and to get into the pockets of those connected with the company. Concepts of 'wrongful trading' and 'shadow director' have been introduced; a broad range of people can now be liable for the debts of the bankrupt without proof of dishonesty and without requiring criminal standard of proof.

This is not an original law. Those familiar with US or UK insolvency legislation will have a strong sense of deja vu. Still, the impact here, on Russian soil, will spread far beyond matters of bankruptcy. It gives a powerful weapon not only to private creditors, but also to the state and, if used properly, it could change the way business is done in this country.

 

Balance sheet test

As the Russian law stands at the moment a company is insolvent when it is unable to pay its debts when they are due - a cash flow test; whether its assets exceed its liabilities is irrelevant.

The purpose is to make liable those who failed to minimise the potential loss to the creditors.
 

From June 5, a company director must also present a petition of bankruptcy if the company's assets are insufficient to discharge its liabilities. The purpose is to make liable those who, as company directors at a time when they knew that there was no reasonable prospect that the company could avoid insolvency, failed to take steps to minimise the potential loss to the creditors.

 

Clawing back

There are a number of provisions, specific to insolvency, under which transactions prior to the insolvency can be unscrambled. These are: 1) transactions at undervalue, 2) transactions intended to defeat creditors, and 3) transactions with preference.

Essentially, these provisions aim to backdate the pari passu principle, the principle of equity among creditors, in order to restrain creditors from jumping the queue and to prevent the insolvent from transferring assets to affiliated persons.

Transactions at undervalue

A transaction which the insolvent entered into at undervalue can be set aside by court if it happened after or a year before the onset of the bankruptcy.

A transaction is an undervalue if the transferor receives no consideration or receives a consideration the value of which is significantly less than the value of the consideration provided by the debtor.

In order to unscramble the deal at undervalue there is no need to prove the motive for the transaction; the law reflects the fact that a company is very unlikely to dispose of its property at undervalue and that, where it does so, there will be a sound commercial motive.

Golden handshakes and other terminal payments can be successfully challenged.
 

Gratuitous payments to employees like bonuses for work done or profit targets met and golden handshakes become vulnerable to attack. Bonuses however effective they may be as inducements are, strictly speaking, given for no consideration. Golden handshakes and other terminal payments are even harder to justify and, arguably, can be successfully challenged.

Similarly, a guarantee or surety can be avoided; in a typical case a guarantee or a surety is given to secure loans extended to another company within the same group. A contract providing security to a previously unsecured loan is vulnerable both as undervalue and preference.

Transactions intended to defeat creditors

A transaction entered by the insolvent with the purpose of prejudicing the property interests of creditors can be unscrambled by court.

A court faced with an application to set aside a transaction under these provisions has to consider, first, the purpose of the transaction, second, whether the other party to the transaction knew of the purpose at a time of the deal, and, third, whether the transaction took place within relevant time - after or three years before presentation of the bankruptcy petition.

The law introduces a broad definition of an 'interested party' or an associate - the one with whom the insolvent is likely to deal at less than arm's length. Where the transaction is with an 'interested party' it will be rebuttably presumed that, if the bankrupt was insolvent at the time of the transaction, the transfer had the purpose of damaging the creditor's interests and the other party knew of it.

The definition of an 'interested party' include the company's affiliated entities, its directors and the chief accountant, including those who had left the office up to two years before the onset of the bankruptcy. Relatives and spouses of these persons are also deemed associates. Finally, those who can have an interest in a transaction according to the general law, unrelated to the insolvency matters, will also be considered 'interested parties'.

In other cases the burden of proof lies with the insolvency practitioner. Keeping in mind that 'damage to the creditor's interests' must be the purpose behind the transaction, and not merely the result of it, and that the other party must be aware of the purpose, it can be difficult for the creditors to prove their case.

Preferences

The law gives a broad definition of preference as a deal which has an effect of putting a creditor into a position which in the event of insolvency will be better than the position he would have been in if that deal had not been done.

Liability for the debts of the company can follow from loss or damage of the company documents.
 

As a general rule, the deal with preference can be set aside if it took place after or a month before presentation of the bankruptcy petition. The relevant period, however, is 6 months before the onset of the bankruptcy if the deal has the effect of granting security to an earlier deal and it can change the position of the creditor in the queue of creditors, or the other party actually knew or ought have known that the bankrupt was insolvent at a time of the deal.

It will be rebuttably presumed that an 'interested party' knew of the insolvency.

Defence

The court may not set aside a transaction at undervalue or a transaction with preference if it is satisfied that the insolvent company entered into the transaction in good faith in the ordinary course of business and that the value of the property in question is less than 1% of the company's assets as at the last reporting date.

 

Liability of directors

In Russia it has been all too easy for directors and controlling shareholders to milk a company, strip its assets and then set up a new company with a similar name engaged in the same business. The burden of establishing fraud to the standards of proof required by the criminal law has proved to be a serious deterrent to Russian insolvency law, and relevant legislative provisions have become almost a dead letter.

The new law adopts the concept of 'persons who control the debtor' - those who de jure or de facto managed the company within last two years before the onset of insolvency. By definition this includes - but not limited to - company directors, its representatives and major shareholders.

'Persons who control the debtor' are jointly and severely liable for the debts of the company in the case of mismanagement or trading in insolvency. The law does not require the proof of intent. Moreover, 'persons who control the debtor' are liable unless they can prove that they acted in the good faith in the best interests of the company.

Liability for the debts of the company can also follow from failure to file the bankruptcy petition at the specified time, or loss or damage of the company documents.

 

The state as the main creditor

Legal institutions are not needed when the winner cannot enforce the court's decision. The Russian market is full of sham companies, which serve different purposes but are mainly needed to evade tax. This tiny little detail, not described in the MBA books or law firms' newsletters, dramatically changes business reality.

Many companies might be surprised to know that their usual way of doing business is no longer viable. The state, as the main creditor, will be tempted to look for the 'deep pockets' and is now able to reach those hiding behind sham structures.

 

 

The law #73-