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The Supreme Court has explained the finer points of secondary liability of controlling entities

26.01.2018
13 min read
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On 21 December 2017, the Plenum of the Russian Supreme Court adopted Resolution No. 53 “On certain issues relating to imposing liability on persons controlling the debtor in a bankruptcy case” (the “Resolution”). It explains both the general principles and grounds for imposing liability on persons controlling a debtor and procedural issues of filing and considering applications to have liability imposed.

Please find below the most important explanations.

The exclusive nature of secondary liability

In view of a significant increase in the number of cases where controlling entities have had secondary liability imposed, the Russian Supreme Court (the “Supreme Court”) has stressed the exceptional nature of such liability. The Supreme Court pointed to the importance of the concept of a legal entity and the inadmissibility of liability, unless actions which triggered adverse consequences for the debtor went beyond the standard business risk and were aimed at violating creditors’ rights. For this purpose courts should be guided by the business judgment rule which has been developed in the sphere of corporate relationships.

Further, the Supreme Court pointed to the secondary application of the general provisions of Chapters 25 and 59 of the Russian Civil Code regarding liability for a breach of obligations and regarding obligations resulting from damage caused.

The criteria for recognising a person as a controlling person have been set out in detail

The Resolution emphasises: (i) the informal approach for establishing the status of a controlling person; (ii) the need to proceed from whether a controlling person in fact exerted a decisive influence on the terms of transactions that changed the economic or legal destiny of the debtor, and (iii) the consideration of advantages that result from the position of persons who are being held liable. The absence of grounds for imposing secondary liability does not rule out liability being imposed on a controlling person by virtue of other rules of law.

The Supreme Court explained that the debtor’s managing company and the director of such a managing company may be recognised to be persons controlling the debtor. Moreover, the general rule is that a figurehead director is subject to liability together with the persons who in fact managed the company.

That does not rule out the recognition as a controlling person of a member holding less than 50% of the votes (shares) or a member of the debtor’s management body who voted together with other members in favour of decisions which materially affected company’s business.

The Supreme Court has spelled out in detail the concept of the benefit necessary to apply the presumption of control in connection with obtaining such benefit. First, the benefit should be substantial relative to the scale of the debtor’s business. And, second, it must be impossible to obtain such benefit if the debtor’s management performed its duties in good faith.

Комментарий ПГ

The presumptions and criteria of the status of controlling persons that are set out in the Bankruptcy Law are refutable. In view of this, we recommend that, when formulating your position in disputes over secondary liability being imposed, you carefully analyse the facts of the case that are relevant to the nature of imputed business decisions and the role of a particular person in adopting and implementing such decisions.

The range of persons and the grounds for imposing liability for the failure to file (timely file) a debtor’s petition for its own bankruptcy set out in detail

It has been explained that a constituent document may not confer the powers to file a debtor’s petition for its own bankruptcy only on one of the directors. And the general rule is that several directors acting jointly or independently will together assume the secondary liability.

An executive manager of the debtor may be released from liability if:

  • although showing signs of insolvency, the debtor's state was not objectively bankrupt;
  • the executive manager counted on overcoming the financial difficulties within a reasonable time and made necessary efforts to achieve the results by implementing an economically feasible plan.

It is possible to restrict an executive manager's liability by only the period when the implementation of such plan was reasonable.

Комментарий ПГ

When a company faces financial or other difficulties in its business, the controlling persons should lay special emphasis on documenting reasonable and necessary measures undertaken to level off the situation, including plans for anti-crisis measures, and the arrangement and implementation of actions to put such plans into effect.

Further, the Supreme Court has relaxed the conditions for the liability of persons other than an executive manager (e.g., a member or a shareholder) for the failure to undertake measures to initiate bankruptcy. The Court stressed that such persons should be advised that the executive manager's obligation has arisen to file a bankruptcy petition with the court and he or she has failed to do so.

The Resolution contains an explanation that the liability of such person is limited by debtor’s obligations that emerged upon the expiry of the aggregate of the maximum time periods set for a meeting of a debtor’s authorised body to be convened, prepared for and held.

The Supreme Court made the point that for a liquidator and members of the liquidation commission the time period for filing a petition for the debtor’s bankruptcy is not one month but 10 days and that the general rule is for the liability of the members of the liquidation commission to be joint and several liability.

The extent of liability for the failure to undertake measures to initiate the debtor’s bankruptcy may be increased by the amount of expenses necessary to perform bankruptcy procedures, unless it is proven that such expenses would have been less if the controlling person had timely performed his or her obligation to file the bankruptcy petition.

When a former executive manager publishes information regarding the onset of the obligation to file a bankruptcy petition with a court, this will release such executive manager from liability with respect to the obligations to creditors that emerged after publication.

Grounds for secondary liability for the failure to meet creditors’ claims in full elaborated

The Supreme Court guides courts to determine controlling persons’ actions which constituted indispensable reasons for the objective bankruptcy of a debtor. Such actions, in particular, may manifest themselves in the making of key business decisions in bad faith and imprudently, in appointing persons to key managerial positions whose performance obviously would not have corresponded to the company’s interests, or in setting up a management system under which third parties would obtain a benefit to the detriment of the debtor.

The need is emphasised to examine the integrity of transactions and other business operations, because the last transaction (operation) may not be treated as the sole factor of the bankruptcy, even if it resulted in a drastic change in the previous disadvantageous financial condition.

The Supreme Court draws attention to the fact that it is crucial to assess both internal and external factors which could have resulted in it being impossible to meet creditors’ claims in full (a general economic downturn, a material change in the business environment, etc.)

Since joint and several liability implies that controlling persons’ actions are concurrent, coordinated and aimed at implementing their common intention, such form of liability, under certain circumstances, may be replaced with pro rata liability based, for example, on the periods when controlling persons exercised actual control over the debtor.

When a creditor writes off debt, including an authorised body under article 59 of the Russian Tax Code, this does not create any impediment to subsequently filing a petition seeking to have the controlling person made liable with respect to such obligations. Nor will this constitute the only ground for excluding the amount of the debt from the amount of secondary liability.

Комментарий ПГ

It is not infrequent for a company to encounter financial problems when its members and management change repeatedly. The explanations focus on the personalisation of liability and establishing persons owing to whose fault the objective bankruptcy occurred. This will obviously result in an expansion of the range of parties who are held liable to include former members, beneficial owners, directors and other persons who influenced the company’s business.

In view of the above we recommend that a person who sells a participatory interest in the company or whose duties as a member of the management body are terminated should consider the risks of being potentially held liable and the consequences of the loss of access to documentation confirming the company’s financial condition.

A court’s wide powers regarding the classification of the legal grounds of a claim codified

No matter how the claimant designated the type of liability and which rules of law it cited, the court will independently classify the claim. If grounds for imposing secondary liability have not been proven but the grounds for other types of liability have been proven, the court will decide to impose that other liability.

Комментарий ПГ

Such an approach significantly improves the position of a claimant, but simultaneously worsens the position of a person who is held liable. In this regard, the controlling person should take a proactive procedural position and substantiate the absence of grounds for the application of both the liability asserted and other forms of liability that may be applied to the circumstances of the dispute.

The presumption connected with the absence or unreliability of a debtor’s documentation elaborated

The Supreme Court has explained the criteria of a significant obstruction to the carrying out of bankruptcy procedures that are required to apply the presumption. It also stated that the failure by a former executive manager to hand over necessary documents to a new executive manager does not release the latter from the liability. A good faith and prudent director must request the documentation from his or her predecessor or try to restore it in another way.

The procedure for filing and reviewing an application for holding a debtor’s controlling persons liable clarified

The Supreme Court has explained the rights of particular parties to initiate having secondary liability imposed on controlling persons. Thus, what we refer to as ‘off-register’ creditors, as well as creditors under current obligations, enjoy the right to file such an application (article 142(4) of the Bankruptcy Law). The latter may file the application outside the bankruptcy case only if the claims are confirmed by a court ruling that has come into legal force, or by a document that is to be enforced by virtue of the law.

In the opinion of the Russian Supreme Court, the ground for a claim seeking to have secondary liability imposed will not be a reference to the rules of law, but to the facts of a dispute. This is the reason why a claim that cites same rules of law but is founded on different offences will not be treated as the same single claim.

As regards the burden of proof, the Supreme Court has explained that if a court-appointed manager and/or creditors, with the help of indirect evidence, have made a compelling argument regarding the status of a controlling person and it being impossible to meet creditors' claims as a result of acts (an omission) of the controlling person, the burden of refuting such arguments will pass to the person who is being held liable.

Комментарий ПГ

The possibility during bankruptcy procedures to reveal new facts confirming illegal actions of a debtor’s controlling persons triggers the risks that interested parties will repeatedly resort to the court seeking to hold the controlling persons liable.

The specific aspects of applying the statute of limitations to a claim for imposing secondary liability unveiled

The Resolution of the Plenum of the Supreme Court regulates in detail the procedure for calculating the statute of limitations when a wide range of potential claimants may claim for secondary liability to be imposed. Specifically, if it is held that one of the creditors has learned or should have learned of the grounds for liability to be imposed before other creditors could have learned of this, the statute of limitations may be applied to a part of a claim seeking that secondary liability be imposed, with part being attributable to the informed creditor.

It has also been noted that, if the court-appointed manager, acting in bad faith, concealed such information from claimants in bankruptcy, the statute of limitations for creditors may not be calculated from the moment when the court-appointed manager learned about the facts constituting grounds for holding controlling persons liable.

Комментарий ПГ

We recommend that persons who are imposed secondary liability carefully analyse the knowledge of each of the creditors in bankruptcy in order to reduce the amount of such liability even if there are indisputable reasons for imposing the liability. Creditors in bankruptcy, in turn, should take a proactive procedural position so as to avoid missing the statute of limitations.

An incentive fee of a court-appointed manager

The amount of the fee depends on the performance of the court-appointed manager and his or her actual input in imposing liability on persons controlling the debtor. Therefore, the amount of the fee may be either reduced or payment may be refused altogether. The amounts of the fee of a court-appointed manager which have been paid out will be recovered from the person controlling the debtor as legal expenses.

Комментарий ПГ

When expenses from the payment of a fee to a court-appointed administrator are recovered from controlling persons the amount of secondary liability increases by 30% of the recovered amount.

What to think about and what to do

Resolution No. 53 of the Supreme Court guides the courts to apply liability mechanisms in bankruptcy prudently and to consider to the fullest extent the whole body of facts relating to companies’ business during the period that precedes bankruptcy. This significantly raises the requirements for the activeness of all parties to litigation over the liability imposed on controlling persons.

Given the current economic situation, the increased awareness of creditors and the focus of competent authorities on the actual recovery of money from controlling persons, we predict a significant increase in the number of such disputes both within bankruptcy cases and outside them.

Our experience of providing legal support in bankruptcy cases and, specifically, projects relating to the liability of controlling persons and contesting transactions shows that whether the defence of controlling persons is effective depends heavily on the risks driven by bankruptcy legislation as early as the stage when business decisions are made.

The lack of awareness of managers and directors of companies of the legal implications of the failure to comply with the Bankruptcy Law raises significantly the risks of adverse effects for the company and its employees including senior managers and other controlling persons.

Help from your adviser

Pepeliaev Group's experts possess extensive experience of protecting the interests of any category of persons involved in the procedures that bankruptcy cases entail. Our lawyers also provide qualified legal assistance in defending the rights of controlling persons who are held liable.

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