The Russian Constitutional Court has changed its approach to the order of priority of legal costs under bankruptcy

Pepeliaev Group advises that the Russian Constitutional Court (the ‘Constitutional Court’) has adopted Resolution No. 11-P dated 19 March 2024The Constitutional Court’s Resolution No. 11-P dated 19 March 2024 “Regarding a case to verify whether the provisions of article 110(1) of the Russian Commercial Procedure Code and articles 5 and 137(3) of the Federal Law ‘On insolvency (bankruptcy)’ are constitutional, in connection with the appeals filed by individuals I.E. Gallyamova and E.P. Chervyakova”.
. Articles 5(1), 5(2) and 137(3) of the Law on BankruptcyThe Federal Law “On insolvency (bankruptcy)”.
 have been checked for compliance with the Constitution as articles stipulating that, in practice, legal costs of the parties to standalone disputes be compensated after the principal debt of third-priority debtors is repaid.

Facts of the disputes

Within the bankruptcy case of PJSC Roskomsnabbank in a dispute over whether transactions were invalid, the court refused to satisfy claims of the receiver against the defendant who had received a number of payments from the debtor.

Within the bankruptcy case of LLC CB Admiralteysky in a dispute over the recovery of losses, the court held that the defendant was not a controlling person and refused to allow the recovery of losses from it.

Both defendants in the bankruptcy cases applied for their legal costs to be compensated. The courts held that the claims were to be satisfied after the principal claims of third-priority creditors (article 137(3) of the Law on Bankruptcy).

Ultimately, the defendants applied to the Constitutional Court.

The Constitutional Court concluded that articles 5(1), 5(2) and 137(3) of the Law on Bankruptcy do not correspond to the Constitution to the extent that, within their meaning, legal costs are to be compensated after settlements with third-priority creditors on the principal debt irrespective of the subject matter of the dispute which was initiated by the debtor or particular aspects of the procedural status of the defendants.Here and below, the above persons are understood to mean defendants in relation to claims of the debtor in whose favour the court judgment has been issued.

Below are the main provisions of the Resolution.

The nature of legal costs of ‘forced’ defendants in standalone disputes

A claim for legal costs to be compensated of persons who have no claims against the debtor and who were forced to join the standalone dispute constitutes a separate principal current claim and meets the characteristics of actual damage.

Legal costs of creditors in establishing claims

The legal costs of a creditor who has lodged a claim against the debtor constitute costs which the creditor assumed voluntarily and which are to be compensated together with the claims of third-priority creditors once the principal claim is settled.

The above approach also applies in a situation where a claim has been established and:

• the court-appointed administrator takes a back-seat;

• there is an actual dispute between the petitioning creditor and the creditors who have filed objections;

• the petitioning creditor has to assume significant costs while proving its point.

Legal costs of controlling persons in disputes to hold them liable

The general approach to the priority order to have legal costs compensated of controlling persons who have won a dispute over secondary liability is that the priority is given to protecting interests of independent creditors. Hence, according to the general rule, compensation of legal costs of the debtor’s controlling persons against whom claims have been dismissed should be lowered in the order of priority.

A defendant who has won a dispute over secondary liability is entitled to claim to have legal costs compensated as current payments only if the court establishes that the defendant has no such status of a controlling person.

Meanwhile, a controlling person of the debtor may claim to have legal costs compensated as current payments based on the following circumstances which characterise the defendant or the debtor and the list of which is an open list:

• the defendant’s membership interest in the debtor’s capital;

• the level of corporate control on the part of the defendant over the debtor’s activity;

• the amount of the costs which are claimed for compensation and the circumstances in which such costs were incurred;

• whether independent creditors are involved in the case.

Neither do the rules for the potential compensation of legal costs as current payments apply to beneficiaries and intra-corporate creditors who have common economic interests with the debtor, because they cannot compete with the claims of independent creditors.

The temporary procedure for the priority of legal costs

The Constitutional Court has formulated a temporary procedure for determining the priority of legal costs for the period until current legislation is amended:

• the defendant’s claims for the compensation of legal costs, where these fall on the debtor, are fifth in the order of priority of current payments if:

• it has been refused to invalidate a transaction of the debtor legal entity and the defendant itself is not a controlling person;

• the court found that the defendant in a dispute over civil-law liability being imposed on it does not have the status of a controlling person;

• legal costs of persons who control the debtor which were incurred in a dispute to challenge transactions or to impose civil-law liability may be classified as fifth-priority payments provided that (and the list of conditions is not exhaustive):

• this does not harm the creditors;

• there are certain conditions relating to the specific features of the person who controls the debtor (the level of corporate control; the amount of costs which are claimed for compensation and the circumstances in which such costs were incurred);

• there are no independent creditors in the bankruptcy case.

What to think about and what to do

We recommend that persons who are forcibly engaged in such legal proceedings use their right to have legal costs compensated in the priority order (for example, parties to transactions that are being challenged or persons who do not have the status of a controlling person). The procedural deadlines should be taken into account for lodging such claims based on the date on which the last court judgment comes into effect in relation to the merits of the dispute.

Risks should also be taken into account of the amount of compensation being reduced based on the general approaches of courts and the correlation between the amount of costs and the volume of claims of the debtor’s creditors as well as other particular circumstances which the Constitutional Court mentioned.

In some cases, the abuse by a court-appointed administrator of its right to initiate standalone disputes may serve as a ground for collecting expenses from it in the amount of the costs which have been classed as current payments in relation to the bankruptcy estate.

We recommend monitoring amendments to bankruptcy legislation regarding the order of priority for the compensation of legal costs since the Constitutional Court established only a temporary procedure.

Help from your adviser

Pepeliaev Group’s specialists have extensive experience of protecting the rights of any category of parties to a bankruptcy case, including contracting parties of the debtor and persons against whom claims have been made relating to secondary liability being imposed or losses being collected.

We also provide legal support to our clients in having their legal costs compensated. Such proceedings are in fact standalone proceedings which are extremely complicated. They require not only that the costs be confirmed but also, if necessary, that their relevance and proportionate nature be substantiated. Yet, the Resolution of the Constitutional Court has added the whole range of legal intricacies which are difficult to figure out without an expert.