Overview of the case law of the Russian Supreme State Commercial (Arbitration) Court in relation to applying insovency (bankruptcy) legislation

Specifics of enforcing the consequences of the invalidity of a transaction whereby a pledgeholder leaves pledged property in its ownership.

(ruling No. VAS-14907/11 dated 20 March 2012)

By the above ruling, the Supreme Arbitration Court (SAC) has actually reinforced the specifics of enforcing the consequences of a transaction transferring a debtor’s pledged property being invalid if it is not possible to restore the parties to their initial position.

In the transaction that was being challenged, a bank had left in its ownership a debtor’s pledged property in the context of enforcement proceedings based on the decision of a court of general jurisdiction to recover of accounts payable and to foreclose the pledged property. The amount of debt recovered from the debtor by the decision of the general court was RUB 8,402,658.06, and the initial sale price of the pledged property was set at RUB 11,270,000. The court bailiff suggested to the bank that it leave the debtor’s property in its ownership at a price that was twenty five percent lower than that value, i.e. RUB 8,560,500, since the property was not sold within two months by a specialised trading company. As a result, the pledged property was transferred to the bank at a price of RUB 8,560,500, and the bank then contributed it to the issued capital of a limited liability company (the “LLC”). The corresponding entries registering the bank’s and then the LLC’s title were made in the Unified State Register of Real Estate Rights and Transactions (the “Register”).

The debtor’s receiver challenged the transaction whereby the bank left on the pledged property in its ownership on the basis of the provisions of article 61.3 of the Federal Law On insolvency (bankruptcy) (the “Bankruptcy Law”). In setting aside the first instance court’s ruling that had rejected the receiver’s application, the appeal court held the transaction to be invalid, based on the value of RUB 8,560,500 for the property in dispute as well as the rights of the creditors second in the order of priority, and the provisions of article 138 of the Federal Law On insolvency (bankruptcy). The court also applied the consequences of the transaction being invalid, making an award in the debtor’s favour against the bank of RUB 1,712,100, i.e. 20% of RUB 8,560,500, having rejected the remaining part of the receiver’s claims.

The SAC’s three judges upheld the conclusions of the appeal and cassation courts with regard to the fact that, since under the provisions of article 138(2) of the Bankruptcy Law 80% of the proceeds that resulted from the sale of the property in dispute were guaranteed as a matter of priority to be designated to repay the claims of the bank as creditor under a loan agreement that was secured by a pledge of the relevant property of the debtor, the remaining 20 percent of the value of the property should be recovered from the creditor in favour of the debtor.

This approach allows banks, when transferring to a debtor 20% of the significantly reduced price of pledged property, to obtain a significant benefit from subsequent transactions with the foreclosed property of a debtor.

Applying to have a company declared insolvent (bankrupt)

when that company has a similar right to demand payment

is evidence of an abuse of law

(ruling No. VAS-2596/12 of the SAC dated 19 March 2012)

The above ruling is interesting from the point of view of whether it is possible to treat as justified a refusal to recognise the claim of an applicant in a bankruptcy case even though there is a court decision confirming that the debtor is showing signs of insolvency (bankruptcy).

In this case a first instance court ruling, which was upheld by the appeal and cassation courts, refused to initiate a supervisory procedure in respect of the debtor and proceedings in the bankruptcy case were terminated.

In applying to the first instance court for the debtor to be declared insolvent (bankrupt), the company pointed to the fact that its debtor had unpaid debts confirmed by a decision of the arbitration court totalling RUB 17,827,200. 53. Of this, RUB 16,142,983.66 was principal debt.

Meanwhile, the company (supplier) and debtor (purchaser) had entered into a supply contract for equipment, and the contract contained a term requiring the goods to be paid for in advance. The debtor transferred an advance payment to the company of RUB 16,997,900. In association with the supplier’s failure to meet its obligation to supply the equipment, the buyer contacted it with a demand that its advance payment for the goods be returned on the basis of article 487(3) of the Russian Civil Code (the “Civil Code”). The company did not return the advance payment.

Based on such actual circumstances of the case, the SAC upheld the conclusions of the appeal and cassation courts in relation to the fact that the company’s application to the court to have the debtor declared insolvent (bankrupt) when the latter had a similar counterclaim regarding the payment in advance made under the contract was evidence of an abuse of law on the part of the company. This abuse took advantage of the fact that the debtor had not set off its similar counterclaims on a timely basis. Taking account of this, the SAC’s three judges cited article 10 of the Civil Code in agreeing that they could reject the company’s application.

In view of the stance the courts took in this case, we recommend that when debtors have counterclaims against an applicant in an insolvency (bankruptcy) case in an amount that is commensurate with the applicants claim, they use abuse of law arguments to defend their rights.

When there is no evidence that a new CEO of a debtor

has been elected and if accounting documentation has been transferred to

the former CEO, the latter may bear secondary liability for

a debtor’s obligations

(ruling No. VAS-2766/12 of the SAC dated 16 March 2012)

Case law of the SAC confirms a general trend of making secondary liability harsher for former CEO’s of debtors in relation to the debts of such debtors.

Within the framework of this particular case, a receiver applied to the arbitration court, asking it to rule that S., a former CEO of a debtor, should bear secondary liability in relation to the failure to perform an obligation to transfer source accounting and financial reporting documents of the company to the receiver.

The SAC’s three judges supported the courts conclusions that the receiver’s claims were justified. This was because S., by virtue of the position she occupied, was liable for arranging that the company’s accounts be kept and be transferred to the receiver.

What company officers need to pay attention to is that the courts regarded as having no legal substance S’s argument that, when the company was declared bankrupt, she was no longer the CEO of the company, her employment contract having been terminated. This was because the financial documents for S’s time working as a director of the company were also not transferred to the receiver. According to the extract from the Companies Register, S. was the company’s CEO because there was no evidence of another person having been elected to this position after the contract with S. was terminated.

In such circumstances, the SAC considered that there were grounds for imposing secondary liability on S. with regard to the debtor’s obligations.

Taking account of this case, we recommend that former CEOs of debtors, once they cease to hold office, document the transfer of all documentation, including accounting documents, to avoid secondary liability of in relation to the legal entity’s obligations to its creditors.

Limitation period for imposing secondary liability runs from

the date when a debtor’s property is sold and not from the

date on which it is declared bankrupt

(ruling No. VAS-487/12 of the SAC dated 15 March 2012)

In reliance on the fact that there were unpaid demands of creditors that had been included in a limited partnership’s register of creditors’ claims and current accounts payable, the plaintiff made a claim to the arbitration court for a ruling that the general partners are jointly and severally liable to bear secondary liability for RUB 6,361,531.90 in limited partnership’s obligations. This amount was the difference between the total of creditors’ claims, including of creditors under current accounts payable, and the case proceeds from the sale of the partnership’s property when it was liquidated.

The resolution of the cassation court had set aside the resolution of the appeal court rejecting the claims and amended the decision of the first instance court, with RUB 5,172,914.73 being awarded against R. as the sole general partner.

In upholding the claims, the court based its decision on the fact that, by virtue of the legal status of a trustee partnership, general partners are jointly and severally liable to bear secondary liability to the extent of their own property for the obligations of the partnership in all cases.

Having examined the supervisory appeal, the SAC’s three judges agreed with the conclusion of the first instance and cassation courts that the limitation period runs from when the debtor’s property is sold, and not from the date when a decision is taken to declare it bankrupt taking account of the provisions of article 200 of the Civil Code.

In view of the above case law, we recommend that, when assessing the risks of secondary liability being imposed, account be taken of the specifics of when the limitation period runs under such type of claims.

Claims of an competent authority that are based on a decision to impose

liability for a tax offence when the decision is imposed after the register

of creditors’ claims is closed, should not be included in the register

(ruling No. VAS-4492/11 of the SAC dated 29 February 2012)

Within the scope of an insolvency (bankruptcy) case of a company that was in receivership, the Federal Tax Service applied to the arbitration court to have debt in connection with mandatory payments included in the register of creditors’ claims (the “register”).

The court’s ruling refused to allow part of the claims to be included in the register, since, to substantiate these claims, the competent authority submitted only a field tax audit report, which in itself entails no legal implications for the taxpayer. A decision to hold the taxpayer liable for committing a tax offence was taken by the competent authority under the procedure from article 101 of the Russian Tax Code after the register was closed. The resolutions of the appeal and cassation courts upheld the original ruling.

In supporting the position of the lower courts, the three judges of the SAC cited the fact that the competent authority’s claims for inclusion in the register reached the court on 12 January 2011 and the register of creditors was closed on 13 January 2011.

In substantiating part of its claims, the competent authority submitted only the field tax audit report dated 26 November 2010. The competent authority’s decision based on the outcome of its consideration of the tax audit materials was handed down and came into force only after the register was closed.

In connection with this, the courts were correct in their conclusions that, when the application was filed, the debtor’s obligation to pay taxes had not come into existence, and that there were no grounds for including such claims in the register. This was because, in the absence of a decision of the competent authority that had come into legal force, the extra taxes and levies could not be considered to have been lawfully established, taking account of the requirements of articles 71, 100 and 142 of the Bankruptcy Law and articles 100 and 101 of the Russian Tax Code.

We also recommend that debtors and provisional administrators use the above approach to determining the date when the grounds for a debtor’s obligations arise to pay additional tax when such debtors and provisional administrators are assessing whether they may include the tax authority’s claims in the register under the supervisory procedure.

A main debtor being excluded from the Companies Register does not entail a

guarantee being terminated, if before that point an application had been filed

to establish creditors’ claims in a bankruptcy case regarding the guarantor

(ruling No. VAS-1842/12 of the SAC dated 24 February 2012)

Within the scope of a bankruptcy case regarding a factory, a claim from a bank based on a guarantee agreement was included in the register of creditors’ claims. Under the terms of this agreement, the factory (as guarantor) undertook to bear joint and several liability with a company to the bank for the company’s performance of its obligations as borrower under a credit facility agreement it had concluded with the bank.

By the arbitration court’s ruling in relation to the company, a bankruptcy (insolvency) case was commenced within the scope of which the bank’s claims based on the credit facility agreement were included in the register. With receivership proceedings completed, the company was liquidated and an entry to that effect was made in the Companies Register.

The bank’s claim was partially satisfied within the scope of the bankruptcy case regarding the company, and this served as grounds for the claims of the receiver of the factory to have a part of the amount of the claims excluded from the register.

As justification for the claim to have the remaining part of the debt excluded from the register, the receiver of the factory relied on the fact that the guarantee obligation was limited only to an obligation to be liable for the debtor, and not to perform the obligation for it. In accordance with article 367(1) of the Civil Code, the guarantee terminates together with the obligation secured by it. Since the company was liquidated and ceased to exist, the bank’s claims based on the guarantee agreement should have been excluded from the register.

The arbitration court’s ruling rejected the claim of the factory’s receiver to exclude from the register of creditors’ claims the unpaid part of the claims secured by the factory’s guarantee. The appeal and cassation courts upheld this ruling.

The highest court supported the position of the lower courts, relying on the following. Under article 363 of the Civil Code, when a debtor fails to perform or improperly performs a secured obligation, a guarantor and the debtor are jointly and severally liable to the creditor unless the law or a contract stipulate that the guarantor will bear secondary liability. Under article 323 of the Civil Code, when debtors have joint and several liability, a creditor may demand performance both in full and in relation to a part of the debt from all debtors jointly, or any one of them individually. Debtors who are jointly and severally liable remain liable until the obligation has been performed in full.

Excluding a debtor from the state register of companies, including as a result of a bankruptcy procedure having been carried out against that particular debtor, does not mean that the guarantee terminates if, before that time, an application has been filed to establish a creditor’s claims in a bankruptcy case relating to the guarantor.

In view of the above approach, we recommend that, if procedures are instituted against guarantors, creditors whose claims are secured by guarantees given by third parties should promptly assert their claims in bankruptcy cases against guarantors in parallel with making claims against the principal debtor.

The consent of each creditor is not required for a debt to be forgiven when

a settlement agreement is concluded in a bankruptcy case

(ruling No. VAS-425/12 of the SAC dated 16 February 2012)

An arbitration ruling in a bankruptcy case approved a settlement agreement. The cassation court upheld the ruling.

The applicant applied to the SAC under the supervisory procedure and pointed to the fact that it was unlawful to include in a settlement agreement a provision about debt being discounted without each individual creditor having consented to this. The applicant also relied on the discrepancy between article 156(1)(2) of the Bankruptcy Law, and clause 13 of the Presidium of the Russian Supreme Arbitration Court’s Information Letter No. 97 dated 20 December 2005 An overview of the practice of arbitration courts heating disputes relating to the entry into, approval and termination of settlement agreements in insolvency (bankruptcy) cases and.

In refusing to refer the case to the Presidium of the SAC, the three judges indicated that the settlement agreement’s provision that debt was to be discounted extended to all creditors whose claims were included in the register. In this event, the separate consent of each creditor for a part of the debt being forgiven was not required, by virtue of article 156(1) of the Bankruptcy Law and based on the clarifications given in the Information Letter of the Presidium of the SAC cited above.

If the debtor fails to perform the terms of a settlement agreement that is being contested, an applicant still has a right to present its claims in the amount stipulated by the settlement agreement under the general regime provided for procedural legislation (article 167(1) of the Bankruptcy Law).

Particular features of the bankruptcy of developers should be applied

in cases brought before paragraph 7 of chapter IX of the Bankruptcy Law

came into the force and if there begin to be settlements with secured creditors

(ruling No. VAS-12527/11 of the SAC dated 8 February 2012)

Many issues come up when the rules governing the bankruptcy of developers are applied, on the part of courts as well as receivers.

A company was declared insolvent (bankrupt) by a decision of the arbitration court and it was placed in receivership. The ruling of the court applied, during the bankruptcy, the rules of paragraph 7 of chapter IX of the Bankruptcy Law. The appeal court’s resolution upheld this ruling.

Using the supervisory procedure to challenge these decisions, the debtor’s receiver relied on the fact that it was unlawful to apply the provisions of paragraph 7 of chapter IX of the Bankruptcy Law in the company’s bankruptcy case since settlements had begun with the third band of creditors in the order of priority.

The SAC supported the position of the lower courts, citing the following. Under article 3(4) of Federal Law No. 210-FZ dated 12 July 2011 On amending the Federal Law ‘On insolvency (bankruptcy)’ and articles 17 and 223 of the Russian Arbitration Procedural Code, in terms of establishing particular features for the bankruptcy of developers who attract funds from persons involved in construction (“Law No. 210-FZ”), arbitration courts apply the provisions of paragraph 7 of chapter IX of the Bankruptcy Law when they hear cases regarding bankruptcy in respect of which proceedings were brought before the date when Law No. 210-FZ came into force, save for bankruptcy cases in which settlements have already begun with creditors of the third level of priority in accordance with the register of creditors’ claims.

In the receivership proceedings, the claim of a secured creditor was partially satisfied using funds from the sale of the pledged property, which fell outside the scope of work performed by the debtor on shared construction terms.

Bearing in mind that the rules for the bankruptcy of developers were aimed at giving additional protection to individuals involved in shared construction and taking into consideration that settlements with creditors in the third level of priority had not yet started, and nor had the sale of the items being built under shared construction conditions, the provisions of paragraph 7 of chapter IX of the Bankruptcy Law should be applied in the company’s bankruptcy case.

The above approach needs to be borne in mind firstly by a court-appointed administrator and also by other persons involved in bankruptcy cases regarding developers when the cases were brought before paragraph 7 of chapter IX of the Bankruptcy Law and are still ongoing.

If a debtor is missing from the register of natural monopoly entities,

this is not an absolute ground for declining to apply to it

rules governing the bankruptcy of this category of debtor

(ruling No. VAS-56/12 of the SAC dated 3 February 2012)

In this case, the Federal Tax Service (the “competent authority”) applied to the arbitration court to have a municipal unitary enterprise (the “debtor”) declared bankrupt on the grounds that it had, for more than three months, more than RUB 9 million of debt in tax and other mandatory payments. The first instance court rejected the claim, and terminated proceedings in the case. This ruling was upheld by the appeal and cassation courts.

The three judges agreed with the lower courts’ assessment of the evidence available in the case, from which it followed that the debtor fell within the class of natural monopolies and the competent authority had provided no evidence to the contrary.

Thus, the courts had reached the correct conclusion that in this particular case it was necessary to apply specific provisions of the Bankruptcy Law. Having established that the terms for bringing proceedings in a bankruptcy case against a natural monopoly, as listed in article 197(3) of the Bankruptcy Law did not apply, the courts had lawfully terminated proceedings in the bankruptcy case having rejected the competent authority’s application to commence a supervisory procedure.

The SAC’s three judges held that the competent authority’s reference to the fact that the debtor was not included in the register of natural monopoly entities was unfounded. This was because such a circumstance is not conclusive evidence of the entity lacking this status, which it may possess when it actually carries out activity producing and/or selling goods (work or services) in natural monopoly conditions.

Taking account of the above position of the court, we recommend that creditors applying for insolvency (bankruptcy) proceedings to be brought against a debtor should analyse beforehand the activity of that debtor in terms of whether it is actually carrying out activity producing and/or selling goods (work or services) in natural monopoly conditions. This is particularly topical in relation to debtors that are unitary enterprises.