New Insolvency Provisions: a Sword of Damocles

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The economic crisis is continuing to dictate new terms for doing business in Russia and most other countries. The Russian Government is trying to keep pace with the changing market environment elsewhere and is setting obstacles to distressed debtors chaotically managing their debts and also selectively favouring the most agile and bold creditors.

On 28 April 2009, the president of the Russian Federation signed new amendments to the Federal Law "On Insolvency (Bankruptcy)" (the "Insolvency Law") and these must be taken into consideration by anyone participating in the market for distressed assets and industries, including but not limited to the shareholders, directors and other members of the management and also, in particular, the creditors of companies suffering financial troubles.

At first sight, most of the amendments appear to reflect the pro-creditor concepts that were extensively introduced into the previous packages of amendments and adopted just before New Year. By digging a little deeper, however, you will find you are highly likely to be forced to take part in bankruptcy procedures in order to be considered as a creditor acting in good faith. In most cases, this means a serious delay in retrieving your money.

To start with, it should be noted that these new amendments de facto introduce two new bankruptcy indicators of a potential debtor: "insufficiency of property" and "non-solvency." Insufficiency of property means that the aggregate value of the monetary obligations (under "civil" transactions) and mandatory payments (taxes and duties) exceeds that of the debtor's assets. This appears similar to the "balance sheet test" in English law, whereas "non-solvency" (inability to pay) refers to the debtor's default on payments under monetary obligations or mandatory payments attributable to capital inadequacy and is reminiscent of the "cash-flow test" in English law. It is extremely important to note that capital inadequacy is assumed in the event of such failure unless there is proof to the contrary.

One the one hand, such an assumption will prevent the management, in control of significant Russian customer companies, from implementing their favorite debt-management game, called "pray for payment," where a payment schedule is established on the basis of personal preferences and only occasionally adheres to the terms and conditions of a specific agreement. At the same time, however, these provisions refer to the obligation of the General Director (or other executive officer) to file for bankruptcy within one month. These provisions are a disturbing restriction on the scope of potential options for ruling out company insolvency, such as debt restructuring or corporate restructuring.

The new provisions are even more important since they "overtly" provide new grounds for challenging the debtor's transactions as voidable by the insolvency officer (external administrator or bankruptcy receiver) on his own initiative or further to a decision by the Creditors' Meeting. The terms, conditions and procedure for challenging transactions were not specifically stipulated by the previous version of the Insolvency Law. This lapse will be eliminated through the enforcement and itemization of such categories as suspicious "undervalue" transactions, suspicious transactions damaging the creditors' proprietary interests and preferential transactions.

As a result, to all intents and purposes, transactions that appeared to a potential debtor and especially to a potential creditor as usual in the normal course of business are now fraught with material risks. These risks are substantially increased by the fact that the rules for challenging transactions apply explicitly to deals and all actions and operations entailing fulfillment of obligations and duties that arise in accordance with the civil, labor, matrimonial, tax and customs legislation and all actions conducted in execution of a court decision, legal acts or acts of other state authorities.

Other key amendments concern implementation of the notion and secondary liability of "a debtor's controlling party." They also establish the liability of the General Director of a company for missing accounting documents and for misstatement of data in the accounts. The increase in the liability of company management constitutes another attempt by Russia's lawmakers to prevent violations of the insolvency rules in the current harsh economic climate, in particular for management already overtly involved in schemes to transfer valuable assets from one company to another in a holding, leaving all the obligations with the "abandoned" one.

To summarize the above mentioned, it should be noted that the new amendments, declared to be "pro-creditor," aim to prevent asset stripping in a company on the verge of insolvency and, in the present context, to expand bankruptcy assets through the filing of claims against third parties. This could potentially provide additional resources for fulfillment of the debtor's obligations to its bankruptcy creditors. At the same time, however, the provisions relating to challenging transactions might constitute an extremely powerful tool in the hands of an insolvency officer, which could, in particular, be leveraged for goals that are far from innocent or honest. That is why the new legal opportunities might have the opposite effect and constitute a Sword of Damocles for the debtor's business partners. They should at least think twice before trying to enforce obligations and/or securities against their debtors. And it is extremely clear that, on occasion, it might appear far easier for managers to institute bankruptcy proceedings than to seek possible arrangements and assume such hair-raising subsidiary liability.