New Rules on Preferences and Vicarious Liability

Tim Stubbs
Head Banking & Finance Group Russia,

The calendar year 2009 has seen a wave of bankruptcy law reforms for Russia. In terms of the “laws on the book,” these were indisputably positive and geared toward strengthening creditors’ rights.

Providers of debt financing bear the largest share of financial risk in most business endeavors. A working bankruptcy system is a “must” for a country’s financial health. This is also true for Russia, which witnessed a wave of debt fin-ancings over the last decade. Russia’s bankruptcy system must protect providers of debt capital and credit suppliers of goods and services. Creditors must know that a debtor’s managers or owners will not strip assets. They must also be assured that the debtor’s assets — or the assets of those who control the debtor, where they abuse their positions — will ultimately answer for the debts.

In this regard, bankruptcy laws ordinarily include rules on two critical areas: namely preferences, the certain types of transactions preceding or following bankruptcy which may be avoided by the administrator; and vicarious liability, i.e. persons who should, by virtue of their abusive control of the debtor, be held liable for its debts (sometimes also called third-party liability).

In June 2009, new rules affecting both of these areas entered into force as part of this year’s bankruptcy reforms (RF Law No. 73-FZ of April 28, 2009; hereafter, the “New Law”).

New Rules on Preferences:

The New Law entirely replaced Article 103 of the Bankruptcy Law (which included the rules on preferences) with more detailed substantive rules and procedures for challenging various transactions as preferences. These are now stipulated in new Articles 61.1 – 61.9 of the Bankruptcy Law.

An administrator may now at his own initiative and on behalf of the debtor (or must, following a decision of the general creditors’ meeting or creditors’ committee) file a claim with the bankruptcy court to challenge a transaction as a preference. This includes both “suspect transactions” and “preferential transactions,” which may be summarized as follows:

Suspect Transactions (i.e. fraudulent conveyances) are transactions designed to strip assets out of the debtor either due to their inherent unfairness (they may be challenged if they took place within one year before the bankruptcy started), or because they were clearly aimed at harming the debtor’s creditors and the counterparty was aware of this (they may be challenged if they took place within three years before the bankruptcy started).

A counterparty is deemed to be aware: if it is “interested,” or if it was aware or should have been aware of the injury to the interests of creditors or of evidence of financial insolvency and/or insufficient assets. The New Law also provides detailed rules for a court to determine when a transaction was “aimed at causing harm.” These include (but are not limited to) cases where the transaction was gratuitous, or where the counterparty was “interested,” or where the amount of assets disposed of (or obligations undertaken) as a result of the transaction (or several interrelated transactions) or liabilities equals 20% (or if the debtor is a financial institution, 10%) or more of the debtor’s asset book value.

Preferential Transactions are transactions concluded with a particular creditor or third party that improves the position of one creditor vis-a-vis other creditors. These may be challenged if they were concluded within one month before the bankruptcy (or thereafter). They include granting security for pre-existing debts, changing priority of settlements, prepayment of debts and the like. They may also be challenged if they took place within six months before the bankruptcy if the creditor was aware of the debtor’s financial insolvency or insufficient assets, or if circumstances evidenced financial insolvency or insufficient assets. (Interested parties are always presumed to be aware.)

The New Law also provides some exemptions from the above rules on challenging suspect transactions and preferential transactions, i.e. transactions entered into on an organized stock exchange; transactions entered into in the “ordinary course of business” where the aggregate value of the transaction (or several interrelated transactions) in question does not exceed 1% of the debtor’s asset book value; or “market value” transactions (where the debtor received fair consideration), which may only be challenged on the grounds of “being aimed at causing harm to the proprietary rights of creditors” as explained above.

New Rules on Vicarious Liability:

Previously, under Article 10(4) of the Bankruptcy Law, third persons (including shareholders, owners, CEOs and others) had vicarious liability “if they had the right to give binding orders to the debtor or could otherwise determine the actions of the debtor that led to bankruptcy” and the bankruptcy occurred due to their “fault.” The law’s provisions were quite vague and provided no specific examples of such control or persons who could be held liable.

Although the basic rule remains the same (requiring demonstration of a “right to give binding orders to the debtor or otherwise to determine the actions of the debtor”), the New Law has now clarified the scope of persons who may incur vicarious liability. It introduces the new concept of a “Controlling Person,” which is defined to include: persons who exercised control at any time within two years preceding the bankruptcy; one specific example of control (“compelling or otherwise influencing the CEO or members of the management bodies of the debtor”) and further specific examples of persons who may be deemed to have such control by virtue of their relationship with and/or position in the debtor, for example, members of the liquidation commission of the debtor; persons with authority under a power of attorney or by law who are able to enter into transactions on the debtor’s behalf; and persons enjoying the right to dispose of 50% or more of the voting shares (or participatory interests) in the debtor.

The New Law amends Article 10 of the Bankruptcy Law (which provides current ground rules on third-party liability) to include: joint vicarious liability among all Controlling Persons (subject to the rules set forth below); a new required element of “harm to proprietary rights of creditors”; a potential reduction in liability if the harm actually caused by a Controlling Person was significantly less than the liability sought to be imposed on him (or it); a potential defense where the Controlling Person acted in good faith and in the interests of the debtor; vicarious liability of the debtor’s CEO for failing to ensure safekeeping of books and records regarding properties or obligations of the debtor; a right of the administrator to file a claim against the Controlling Persons on his own initiative and/or following a decision of the creditors’ meeting or creditors’ committee within the bankruptcy proceedings; if an administrator brings a claim against Controlling Persons, a prohibition on termination of bankruptcy proceedings until a ruling is made on such claim; a return to the bankruptcy estate of funds recovered from persons held vicariously liable; and the right of Controlling Persons to bring actions for compensation against other persons culpable for harming the creditors’ proprietary rights.

The above changes bode positively for creditors and the continued development of Russia. This said, the main challenges for Russia include not only providing new bankruptcy rules, but no less importantly an objective, fair and reliable judicial system to implement such rules.