6 November 2002
New Regulation On Insolvency in the Russian Federation

Since inauguration of Russia’s first bankruptcy law in early 1990-ies, insolvency procedures where routinely used as an instrument of hostile takeovers. Provisions of than-current Bankruptcy law that effectively restricted the right of debtors to appeal decisions of courts on interim issues in the course of bankruptcy proceedings were even held unconstitutional (and thus void) by the Constitutional Court of the Russian Federation.

This action and other developments prompted the complete overhaul of bankruptcy regulation. Third revision edition of bankruptcy regulations adopted by the Federal Law On Insolvency (Bankruptcy) No. 127 FZ dated 26 October 2002 (the “Law on Insolvency”), which is discussed here, endeavors to provide for a balanced approach to interests of a debtor and its creditors.

Overview.

Bankruptcy proceedings remain within the competence of commercial (arbitrazh) courts. No special bankruptcy courts exist. However, the threshold cumulative amount of unsettled liabilities sufficient to trigger bankruptcy proceedings is increased to a minimum of 100,000 Rubles (approx. USD 3,500) with a condition that these debts remain delinquent for more than three months. Moreover, in order to initiate involuntary bankruptcy procedure such claims should be liquidated in amount and confirmed by a valid court judgement (under a previous law a creditor could have merely allege the indebtedness, even though the existence and amount of debt were disputed by a debtor). The latter rule does not apply in case of a voluntary bankruptcy application; however, as a measure of deterrence against possible abuse, the court now has given discretion to decide whether commencement of the voluntary bankruptcy proceedings is justified upon the facts of the matter.

As a result, the number of bankruptcy proceedings has dropped substantially: only 14 277 bankruptcy petitions were filed in 2003, compared to 106 500 in 2002.

The Law On Insolvency has also introduced another device to let the owners of debtors retain in control over the company. They are now allowed to take part in the procedure and, importantly, have the right to pay off creditor’s claims at their own account to prevent the debtor from going into liquidation. Such bail out payment can be also made by any third person. After satisfying all demands of creditors such shareholder would become the sole creditor of the debtor and would effectively retain control over it
Procedures.

If the court determines that bankruptcy procedures are justified, it orders supervision (preliminary determination), which has the goal to assess financial situation of the debtor, prevent dissipation of the assets and work out the course for further action in the matter- closing of the proceedings, including by the way of settlement with creditors, financial rehabilitation, external management or straight bankruptcy (competition) procedures.

A court ordering supervision should also appoint a Temporary Manager and determine its remuneration. Under the previous regulation, a Temporary Manager in addition to powers of his special capacity, was able to replace the debtor’s CEO (in case of dismissal of the CEO by the court upon respective motion of the Temporary Manager), i.e. virtually step in the shoes of the CEO of the debtor and have the same broad powers in steering the debtors’ business. Needless to say, Temporary Managers were not in always prone to abstain from abusing these powers. This deficiency was corrected by the Law on Insolvency, which now provides for appointment of CEO by arbitration court from the candidates proposed of founders (or participants) or other control body of the debtor or the representative of the owner of property of the debtor-unitary enterprise. In this way CEO (representing owners) and Temporary Manager (representing debtors) continue to balance each others’ acts. During the supervision period, a Temporary Manager determines the financial situation of the debtor, registers creditors’ claims and convokes the first meeting of creditors. CEO retains power, although somewhat limited, to manage current operations of the debtor.

At this first meeting is an important step in bankruptcy proceedings, where creditors develop suggestions regarding the mode of further proceedings in the case: financial rehabilitation, external management, straight bankruptcy (competition) procedure, or amicable settlement. The weight of a creditor’s vote in the meeting is proportional to the amount of its claim. The decision of the first meeting of creditors regarding the preferred type of bankruptcy procedure is submitted to a bankruptcy judge, but is not binding upon the latter. The judge has a broad discretion to determine the proper way to go forward. Essential aspects of available options are as follows.

Financial rehabilitation is the new mode of bankruptcy procedure introduced by 2002 revision of the law. Financial rehabilitation may be ordered by a court if the debtor’s founders or participants (shareholders) or the agency authorized by the owner of debtor’s property (in case when the debtor is a unitary enterprise) or the third persons (as it is mentioned before) make such decision. Its purpose is to restore the debtor’s ability to work out cash flow problems and repay its debts in accordance with a schedule. When the arbitration court rules to introduce a financial rehabilitation it must simultaneously appoint an Administrative Manager (trustee). During the procedure of financial rehabilitation regular management bodies of the debtor retain the office, but their powers are restricted.

If an arbitration court considers that rehabilitation of the company is possible, it may order the external management. Upon appointment by the court, an External Manager must develop an external management plan and submit it to the meeting of creditors for approval. In order to restore the solvency of the debtor, the External Manager may use the following measures: change of business profile, dispose of unproductive assets by sale or otherwise, manage, and/or optimize accounts payable and receivable. The sale of the debtor’s property as an ongoing concern may be included in the rehabilitation plan and realized through the open sale in the form of an auction.

The number of the available financial rehabilitation measures is increased as compared to the previous law. Management bodies of the debtor are authorized to adopt a decision concerning: the increase in the charter capital of a debtor by means of the placement of additional common stock; the substitution of assets of the debtor; performance of obligations of the debtor by the owner of property of debtor-unitary enterprise, founders (or participants) of the debtor or third persons.

The arbitration court’s decision to declare the debtor a bankrupt entails opening of a straight bankruptcy (competition) procedure. The purpose of this procedure is to perform accounting of debtor’s assets, determine an efficient way of distribution of the assets and proceeds among creditors. The straight bankruptcy procedure ends up with liquidation of the debtor company.

The bankruptcy procedures can also be closed by amicable settlement between the debtor and its creditors at any stage.

The ranking of creditor’s claims in bankruptcy proceedings is different from common ranking found in the RF Civil Code. The Law on Insolvency provides for three ranks of creditors. Importantly, fiscal claims (e.g. tax arrears and penalties) now rank equal with general commercial claims (they had a priority under the previous law). Claims secured by pledge have priority over other claims of the same rank, except claims of first and second ranks that have originated prior to the date of pre-dating the respective pledge contract.

Bankruptcy proceedings shall be completed within the period not exceeding seven months from the date of receipt of the bankruptcy application (statement) by the arbitration court.

Putting in place an effective bankruptcy system involves more than just establishing laws and procedures. Russian emerging market economy, lack of bankruptcy traditions (first bankruptcy law was introduced in the course of reforms only 12 years ago) and infrastructure constrain implementation of progressive legislative developments. The new bankruptcy regulations discussed above repaired some of the most serious deficiencies found in the prior laws. However, as the practice of bankruptcy and insolvency procedures in Russia grows and matures, it will sure command further developments in this area.