Understanding insolvency proceedings in Russia

January 2014 | PROFESSIONAL INSIGHT | BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

There is a stark contrast between insolvency in Russia compared to Western jurisdictions; the rules of the game are very different. Based on experience, the less an uninitiated player from overseas is prepared for a bitter fight in Russia, the heavier the loss it will suffer as a result of the insolvency of a Russian counterparty. Russian insolvency proceedings are often used by the debtors’ management and majority creditors not for the legitimate purpose of rehabilitating the company’s solvency or satisfying creditors’ claims, but for illegal purposes such as stripping the company’s assets.

The Russian Law on Insolvency (Bankruptcy) No. 127-FZ dated 26 October 2002 (the ‘Insolvency Law’) does not provide a minority creditor with sufficient tools to prevent possible abuses by the debtor’s management or the majority creditors. When an insolvency procedure is commenced in respect of a Russian company, the minority creditor must make a (unilateral) decision as to what strategy it will take in the insolvency proceedings.

Passive or aggressive?

In a passive strategy, a minority creditor performs only those actions which are required for the formal inclusion of its claim into the creditors’ register and defends its claim if challenged by other creditors. The only advantage of such a strategy is the lack of significant expenses. Creditors who opt for this approach usually lose any control over the bankruptcy proceedings and their claim often remains unsatisfied.

An aggressive strategy consists of the minority creditor using each and every right and opportunity available to it under the Insolvency Law in order to prevent the abuse of its rights, the stripping of the insolvent company’s assets and other types of misconduct.

Aggressive strategy in a bankruptcy case

Depending on the type of bankruptcy proceedings in question, active participation in the insolvency proceedings may include a combination of the following: (i) review of claims made by other creditors, filing objections to any arguably inflated claims or appealing against the inclusion of such claims into the register; (ii) review of transactions entered into shortly before the commencement of bankruptcy proceedings, challenging transactions entered into to strip assets or create inflated debts to bad faith creditors, and requesting the external manager or liquidator to challenge such transactions; (iii) attempting to exercise control over the actions of an insolvency manager and applying for the removal of an insolvency manager who acts in violation of the law; (iv) challenging decisions of the creditors’ meeting; (v) active cooperation and joint strategic action with other minority creditors; and/or (vi) electing a representative to the creditors’ committee.

Although an aggressive strategy usually involves significant legal costs, practice shows that in certain cases it can be effective. For majority Russian creditors seeking full control over a debtor’s bankruptcy, it is often preferable to buy out the claims of an ‘aggressive’ minority creditor than to be in conflict throughout the course of the proceedings.

Preventing the inclusion of bad faith creditors’ claims in the register

One of the ways to illegally maintain control of the insolvent company commonly used in Russia is to artificially create a large inflated debt (for example, by issuing promissory notes of exchange or providing suretyships for the obligations of third parties). This is done in order to secure the subsequent inclusion of the creditor’s claim arising from this debt into the register. This can allow a bad faith creditor (who is often indirectly affiliated with the shareholders of the insolvent company) to obtain the majority of votes at a general creditors’ meeting.

Good faith creditors may prevent the inclusion of such inflated claims in the register by raising an objection with the court. However, the Insolvency Law allows a creditor to object to the inclusion of other creditors’ claims only after its own claim has been formally submitted. Therefore, it is very important that a creditor file its claim as soon as practicable after official notice of the start of the insolvency proceedings is published. This can be logistically problematic for foreign creditors of a Russian company.

Another problem is that when considering the applications of the creditors for the inclusion of their claims in the register, courts usually limit themselves to the formal verification of the validity of and grounds for such inclusion. The courts generally do not perform a detailed analysis of the validity of the transactions giving rise to the inclusion of claims in the register and indicate that other creditors have the right to challenge these transactions separately.

Challenging transactions and removing the insolvency manager

Transactions entered into by a company prior to the insolvency proceedings can be challenged either on a general basis (such as on the grounds of abuse of rights) or on the basis of so-called specific grounds under the Insolvency Law (transactions at undervalue and transactions giving preference) (the ‘Specific Insolvency Grounds’).

Proving abuse of rights by bad faith creditors is extremely difficult due to the fact that the courts are rather inconsistent in their interpretation of this concept under Russian law. Therefore, good faith minority creditors have to wait for external management or the liquidation, because the insolvency manager may only contest the insolvent company’s transactions on the Specific Insolvency Grounds at this stage. Practice shows that this can be too late, as artificially inflated claims may grant decisive votes to bad faith creditors at the initial stage of the insolvency, when pivotal decisions are made about the next insolvency stage and the candidacy of the insolvency manager.

Despite the fact that the insolvency manager is formally supposed to be independent, in practice Russian insolvency managers act in the interests of the person who nominated them for this position. Accordingly, if the insolvency manager was nominated by a creditor whose claims are based on invalid transactions, it is extremely unlikely that such an insolvency manager will challenge the transactions entered into by the insolvent company with this creditor.

Only the creditors’ meeting or the creditors’ committee can oblige the insolvency manager to challenge the insolvent company’s transactions. However, as pointed out by the Russian Supreme Commercial Court in its Decree No. 63, in order to challenge a transaction a single creditor must apply to the insolvency manager with a proposal based on the Specific Insolvency Grounds. If the insolvency manager refuses to accept such an application to challenge the transaction, the creditor is entitled to file a complaint to the court requesting that it dismiss the insolvency manager.

There is now recognition that insolvency managers must reasonably assess the arguments presented by creditors and challenge any suspicious transactions in order to protect the interests of good faith creditors. On this analysis, the insolvency manager is entitled to reject a creditor’s request only if there are strong grounds to believe that the transaction in question does not contradict the Insolvency Law. Furthermore, in its recent Decree No.59, the Russian Supreme Commercial Court established that in the event that an insolvency manager illegally fails to challenge a transaction or delays such challenge, a creditor may itself contest the insolvent company’s transactions on the Specific Insolvency Grounds. However, despite the guidelines of the Russian Supreme Commercial Court, the lower courts are still very inefficient in invalidating fraudulent transactions made by insolvent companies in anticipation of their insolvencies.

Also, dismissing an insolvency manager who has acted illegally is often a hollow victory, since the majority creditors may simply convene another creditors’ meeting and ensure the election of another loyal insolvency manager.

Challenging the decisions of the creditors’ meeting

Having obtained control over the majority of votes at the creditors’ meeting, a bad faith creditor can ensure that the creditors’ meeting makes any decisions it wishes. Even the subsequent exclusion of an inflated claim from the insolvency register may not guarantee a successful challenge of decisions made by the creditors’ meeting with the bad faith creditor’s involvement. Most Russian courts take a very formalistic approach and refuse to overturn decisions of the creditors’ meetings. The courts argue that the Insolvency Law entitles creditors whose claims are included in the register at the moment of the respective creditors’ meeting to make decisions and that any consequent exclusion of a creditor from the register does not constitute grounds to annul decisions taken by the relevant creditors. Only a few Russian courts have taken the opposite approach, and reconsidered the decisions of a creditors’ meeting where such decisions had been influenced by a creditor with a large and arguably inflated claim.

Creditor’s representative in the creditors’ committee

The insolvency manager or the majority creditors can often convene numerous creditors’ meetings to consider relatively unimportant items. This is aimed at reducing the attention paid by good faith minority creditors to the proceedings. However, if a minority creditor whose vote can influence the outcome of the voting does not attend such meetings, the insolvency manager or majority creditor may add additional items to the agenda, which will then be decided without the votes of minority creditors. It is therefore advisable for any creditor whose vote can influence an important decision to participate in every creditors’ meeting of the debtor, regardless of the proposed agenda.

In fact, the only important decision which may depend on the votes of minority creditors is the election of the members of the creditors’ committee. Since the members of the creditors’ committee are elected by cumulative voting, even the creditors whose claims together constitute a third or less (depending on the number of members of the committee) of the total amounts of creditors’ claims may be able to elect a representative to the committee.

A representative of a minority creditor to the creditors’ committee is often not in a position to influence the decisions of the committee (since such decisions are made by majority vote of committee representatives). Nevertheless, having such a representative allows a minority creditor to be kept informed of all decisions made by the creditors’ committee and, if necessary, to contest such decisions.

Conclusion

The choice of possible strategy of a minority creditor in Russian insolvency proceedings depends on a number of factors such as the amount of claim, the share of the claim in the total amount of creditors’ claims and whether its claim is secured by a pledge of the debtor’s assets. Another important issue is the creditor’s budget for the insolvency case. Practice shows that an aggressive creditor has an improved chance of satisfying its claim (usually due to being bought out by the majority creditors), while the claims of a ‘dormant’ creditor, unless they are secured, are often not paid out at all when the company is liquidated.

Grigory Marinichev is a partner at Morgan, Lewis & Bockius LLP. He can be contacted on +7 495 212 2420 or by email: gmarinichev@morganlewis.com.

Grigory Marinichev

Morgan, Lewis & Bockius LLP