RUSSIA ADOPTS NEW BANKRUTPCY LAW

 

by Ethan S. Burger, Esq.1

Russian - Ukrainian Legal Group, P.A.

(Washington, D.C., Moscow and Kiev)

 

 

            Background

 

            Given the rate of technological change in recent years, it is not surprising that small and medium enterprises account for a disproportionate share of job creation in the western-developed economies.  If the Russian economy is to develop into an efficient market economy, it is essential that its small enterprises2 thrive.  This will depend, in part, on the liquidation of inefficient large enterprises.  The very existence of many Russian enterprises’ huge tax debts indicates that the existing Russian bankruptcy system has not worked.  While there is a complex amalgam of historical, political, legal and social factors that have contributed to this situation, the economic consequences are quite tangible.  As noted by Anders Cslund of the Carnegie Endowment for International Peace:

 

“disinterested and incompetent managers of former state-owned enterprises are tying up valuable resources – machinery, equipment, premises and labor force – in large enterprises that do not function.  Such resources need to be released, and logically, much should be transferred to the small enterprise sector.  In particular, small Russian enterprises are repressed by the scarcity of affordable premises, whereas large enterprises have abundant space that is not used.”3

 

With the recent adoption of the Russian Federation Law “On Insolvency (Bankruptcy)”,  (hereinafter the “Bankruptcy Law”), signed by President Yeltsin on January 8, 1998, Russia has taken another significant step towards rectifying the situation.  The new Law enters into effect on March 1, 1998.

 

            The Bankruptcy Law replaces the Russian Federation Law “On Insolvency (Bankruptcy) of Enterprises”, dated November 19, 1992 (hereinafter the “Old Bankruptcy Law”).  Since the adoption of the Old Bankruptcy Law, the Russian legal regime has made major (although imperfect) strides in the development of legislation connected to bankruptcy and creditors, marked most notably by the adoption of a new Civil Code (Part I), dated November 30, 19944 , a new Criminal Code, dated March 24, 19965 , the Law “On the State Registration of Rights to Immovable Property and Related Transactions”, dated July 21, 1997, and the Law “On Executory Procedure”, also dated July 21, 1997 (concerning the enforcement of judicial decisions).6 During this period of more than five years, Russia’s business community, courts, and tax collectors have struggled with the imperfections of the substance and procedure of Russian bankruptcy legislation.   The new Bankruptcy Law reflects to some degree the lessons learned as a result of this experience.

 

            Organization of the New Bankruptcy Law and Some Key Provisions

 

            The Bankruptcy Law consists of 189 separate articles, organized into twelve chapters: (i) General Provisions, (ii) Prevention of Bankruptcy, (iii) Procedure for Cases on Bankruptcy in the Arbitrazh Court,  (iv) Supervision, (v) External Administration, (vi) Competitive Procedure, (vii) Settlement Agreement, (viii) Peculiarities of Bankruptcy of Separate Categories of Debtors- Legal Entities, (ix) Bankruptcy of Citizens, (x) Simplified Procedure for Bankruptcy, (xi)  Voluntary Announcement of the Bankruptcy of a Debtor, and (xii) Final and Transition Provisions.    

 

The Bankruptcy Law offers a better road map for bankruptcy cases than that offered by the old Bankruptcy Law.  It is more “user friendly” than its predecessor.  For example, the Bankruptcy Law identifies separate procedures that better correspond to actual stages in a particular bankruptcy case: supervision, external administration, competitive procedure and settlement agreement (Article 23), whereas the Old Bankruptcy Law set out three separate procedures: reorganization, liquidation and settlement agreement (Old Bankruptcy Law, Article 2).

 

            Supervision is a new interim procedure aimed at preserving a debtor’s assets until such time as an arbitrazh court can determine whether the debtor is insolvent. Generally, supervision begins upon the submission of a bankruptcy application to an arbitrazh court and will last 3 - 5 months (Articles 47 and 56). If the court finds the debtor to be insolvent, on the basis of a decision of the first assembly of creditors, it will:

 

(i)    place the debtor under external administration during which a plan is adopted and implemented aimed at restoring the debtor’s financial health. This plan can involve changing the profile of the debtor’s production activities, the sale of part of the debtor’s property, assigning its claims to creditors and other measures (Article 85). During the period of external administration (which may be for an initial twelve-month period that can be extended by up to six additional months), a debtor benefits from a moratorium on the satisfaction of creditor claims (Article 70);

 

(ii)  initiate a competitive procedure resulting in the debtor’s liquidation and the disposal of its property within a one-year period, unless such period is extended by the court for an additional six-month period (Article 97); or

 

(iii) approve a settlement agreement with the creditors (Article 120).

 

In addition, the Bankruptcy Law provides for a simplified procedure that can be used if it is clear that a debtor’s property is insufficient to satisfy all creditor’s claims (Article 174-76), as well as for a voluntary bankruptcy procedure (Article 181-84).

 

The new Bankruptcy Law’s superiority over its predecessor reflects the   drafters’ better understanding of the complexity of the subject matter (illustrated by the fact that it has 189 articles whereas the old law had only 51) and new legal concepts and norms that have developed in Russian civil and corporate law.   No doubt, the various actors involved in the bankruptcy process, in particular, arbitrazh  judges, members of the assembly of creditors, other “interested persons”, and the various arbitrazh managers (temporary manager, external manager, and competitive manager) will be pleased that there are now better rules on which to base their actions.

 

Not surprisingly, the Bankruptcy Law also contains special provisions on job retention by members of a debtor’s work collective in the event of an enterprise’s sale (Article 86) and for the possibility of state subsidies to keep an otherwise insolvent large enterprise (one having more than 5,000 employees or an enterprise, the number of workers along with their family members of which constitute not less than 50% of a given locality’s population - hereinafter a “Large Enterprise”). The Bankruptcy Law envisions the possibility of state guarantees of such Large Enterprise’s obligations to creditors for an initial one-year period. This period may be extended for an additional ten years (Articles 132-35).

 

The Bankruptcy Law is too complex to describe and analyze in a brief article.  The items discussed below relate to certain provisions involving the bankruptcy of private legal entities (though the Law also covers the bankruptcy of individual entrepreneurs) that are certain to be of interest to persons active in the Russian market:

 

n      The Bankruptcy Law requires the head of a debtor or its liquidation commission to submit an application (zayavlenie) to the relevant arbitrazh court, (hereinafter a “bankruptcy application”), if (i) the satisfaction of claims of one or more creditors may lead to the impossibility of the performance of monetary obligations of the debtor in full volume with respect to other creditors or (ii) an authorized body of such debtor adopts a decision to file a bankruptcy application with such court (Article 8)7 . Such application must be submitted within one month of the occurrence of the relevant circumstances.  Heads of debtor enterprises and members of an enterprise’s liquidation commission are secondarily liable to creditors for the failure to submit a bankruptcy application if so required, and under certain circumstances, may face criminal sanctions as well (Article 9).  Under the Old Bankruptcy Law, a debtor “had the right”, but was not explicitly required, to submit a bankruptcy application.  Similarly, creditors and procurators had the right to submit a bankruptcy application concerning a particular debtor (see Articles 4 through 8).  Since it would often not be in the interests of any of those authorized to initiate a bankruptcy case to do so, insolvent Russian enterprises have been allowed to continue to exist.

 

n      Generally, if there is not a legal basis for placing a debtor under external administration for the purpose of restoring it to a position of financial solvency, the Bankruptcy Law provides that a Russian arbitrazh court should deem a debtor to be bankrupt (and make arrangements for the initiation of the competitive process for the disposal of the debtor’s assets).  The Bankruptcy Law identifies the characteristics of insolvency as the inability of a debtor to: (i) satisfy the claims of creditors for monetary obligations, and/or (ii) make obligatory payments (such as to the various budgets and non-budgetary funds), if the relevant obligations and/or payments have not been accomplished within three months of the date of their accrual (Articles 3 and 49).  This approach eliminates the need for the arbitrazh court to examine the value of the debtor’s assets and liabilities, as was required previously under the Old Bankruptcy Law (Articles 1 and 10).

 

n      The Bankruptcy Law provides that an arbitrazh court may order conservatory measures identified in the Arbitration Procedural Code or prohibit the accomplishment of certain transactions unless approved by the arbitrazh manager to prevent the depletion of the debtor’s assets.   Such transactions include those (i) connected with the rent, pledge, contribution into the charter capital of another entity or other disposal of immovable property, (ii) disposal of other property exceeding 10% of the balance sheet assets of the debtor, or (iii) the receipt or issuance of loans or credits, the issuance of guaranties, the assignment of rights of claim, transfer of debts or the placement of property under trust management (Articles 44 and 58).  During the period of a debtor’s supervision, an arbitrazh court is empowered to replace the debtor’s management for actions that will harm the interests of the debtor or the creditors.  These provisions are aimed at reducing the risk that a debtor’s assets will be moved by a debtor’s owners or management to related entities to deny them to creditors.

 

n      The Bankruptcy Law appears to limit the risk that creditors will be able to pierce the corporate veil of a Russian legal entity that becomes insolvent where there has not been improper conduct.   This is an important development since Article 56, Point 3 of the Russian Civil Code provides:

 

“If the insolvency (bankruptcy) of a legal entity is caused by its founders (participants), by the owners of the property of the legal entity or by other persons having the right to give obligatory instructions to the legal entity, or in another manner have the possibility to determine its activities, then such persons in the event of the insufficiency of the property of the legal entity may be secondarily liable for its obligations.”

 

Since the Russian Civil Code contains no definition of the word "caused", there has been a fear that the above identified persons would face secondary liability for the debts of insolvent legal entities even absent a showing of fraud or other illegal conduct.  The Bankruptcy Law suggests that this is possible only in cases of intentional bankruptcy (Article 10).8 Unfortunately, the Bankruptcy Law does not offer a definition of “intentional bankruptcy”.  The Russian Criminal Code, however, defines “intentional bankruptcy” as “the intentional establishment or increase of lack of payment capacity (neplatezhesposobnost’) accomplished by the head or owner of a commercial organization . . .in [his/its] own interests or the interests of others, that causes major harm or has serious consequences” (Criminal Code, Article 196).

 

The Bankruptcy Law represents a major evolution in the level of detail and procedure to be used for Russian bankruptcy matters.  Its application may lead to an increased pace of the breakup of inefficient enterprises since insolvent debtors are now required to initiate their own bankruptcy procedure and creditors are less likely to choose to sit on their unpaid bills. While there are extreme budgetary pressures at all governmental levels, political leaders fear the consequences of massive layoffs. Consequently, it is impossible to predict whether state and local authorities will issue guarantees to Large Enterprises to prevent their liquidation.

 

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1           Mr. Burger is Counsel to the Russian - Ukrainian Legal Group, P.A., (“RULG”) a Washington-based law firm providing legal support and in-country advice to large and medium-sized international corporate clients doing business in Russia and Ukraine.  For more information about RULG, visit its Web Site at www.rulg.com.

 

2           Russian legislation is not consistent in its use of the term “small enterprise”.  Various items of legislation use different definitions that depend on the particular sector of concern and the legislative purpose.  Generally, Russian tax legislation regards a small Russian enterprise as one having 200 or fewer employees (see Law of the Russian Federation “On Investment Tax Credit”, dated December 20, 1991, as amended.  Other legislation regards small enterprises as having 100 or fewer employees (see Law of the Russian Federation “On State Support of Small Entrepreneurs in the Russian Federation”, dated June 14, 1995).  Thus, many Russian “small enterprises” would be considered to be “medium” in most western countries.

 

3           Anders Cslund, “ Observations on the Development of Small Private Enterprises in Russia”, in Post Soviet Geography and Economics, Vol. 38, No. 4, 1997, at p. 203.

 

4           The Civil Code contains provisions on the priority of creditors in the event of the liquidation of an enterprise (Article 64), on the insolvency (bankruptcy) of legal entities (Article 65), and methods to secure the performance of obligations (Chapter 23), including detailed rules on pledge (Articles 334 through 358).

 

5           The Criminal Code provides for a whole host of new economic crimes such as Improper Actions during Bankruptcy (Article 195), Intentional Bankruptcy (Article 196), and Fictitious Bankruptcy (Article 197).

 

6           see this author “New Legislation on Enforcement of Judicial and Arbitral Decisions in Russia”, U.S.-Russia Business Council’s Russia Business Watch (Summer/Fall 1997).      

7           Creditors or procurators have the right to submit a bankruptcy application to an arbitrazh court concerning a debtor in connection with its non-performance of monetary obligations.  In addition, tax and other authorized bodies have a similar right with respect to a debtor’s failure to make budgetary and other obligatory payments (Article 6).

 

8           Both the Law on Joint Stock Companies, dated December 26, 1995, and the draft Law on Limited Liability Companies, as approved by the State Duma on January 14, 1998, contain language less restrictive than that found in the Russian Civil Code, but not as restrictive as that of the Bankruptcy Law.