Management Liability for Deliberate Insolvency in Russia

01 а€бѓаЛбЅ 2010

Summary

Russian legislation provides for certain types of management (and/or founders-of-legal-entitiesтЂ‰) liability for deliberate insolvency. Issues of administrative and criminal liability by founders and management have become real problems. It is impossible for a companyтЂ‰s management to ignore the possibility of administrative or criminal prosecution. Yet company management and founders who often consider themselves as being safe have a not liability that is very real. This article sets out the main provisions relating to companies before examining civil liability for deliberate insolvency and describing the provisions relating to administrative and criminal liability.

Main Provisions for Companies

Bankruptcy caused by the founders, by the owner of the assets of a legal person or by other persons who have the right to give binding instructions to the legal person or in some other manner have the capacity to determine its acts is known as a deliberate bankruptcy. Liability for such acts may be imposed both on the founders and managers of the company.

The features of deliberate bankruptcy can be identified both during the period preceding the initiation of bankruptcy and during bankruptcy proceedings. The subsidiary liability prosecution of persons causing the insolvency of the company starts no earlier than the introduction of the competitive procedure (comparable to administration or receivership in the UK), i.e., after the court renders a guilty verdict in the case of the deliberate insolvency. Until completion of the competitive procedure, only the competitive manager has the right to start prosecution proceedings. Creditors may apply to the court on subsidiary liability of the management only after the completion of the competitive procedure, if the competitive manager has not already started such an action.

Acts committed in anticipation of bankruptcy of the company and causing damage to all or some of creditors, including the concealment of the debtorтЂ‰s assets or its obligations, are also considered wrongful acts by the debtor or the owner of a company.

The presence of guilt in the form of direct intent (akin to the concept of тЂ€mens reaтЂ‰ in UK criminal law) as well as proof of a cause-and-effect relationship of deliberate acts causing bankruptcy is a prerequisite for the imposition of civil liability. The requirements for persons bearing subsidiary liability may be claimed only by the external manager (comparable to the administrator or receiver in the UK) for the inclusion of recovered amounts in the assets of the debtor and the creditorsтЂ‰ claim settlements.

The competitive manager may claim against third parties who have subsidiary liability for the obligations of the debtor under Russian Federation legislation.

The performance of acts/omissions by director or founder of a legal entity that obviously entails the failure of that legal entity to fully satisfy the creditorsтЂ‰ claims on monetary obligations and/or to fulfill the obligation to pay mandatory charges, providing these acts/omissions do not include a criminal element, the law sanctions liability for these acts as a penalty in the form of the imposition of an administrative fine on officials in the amount between RUB 5,000 and 10,000 or disqualification for a period of one to three years.

Criminal liability results if the insolvency of the legal entity does not occur as a result of objective economic conditions but due to the deliberate acts of perpetrators. The crime is deemed to have been committed by managers or founders of the legal entity. Such a crime is committed with deliberate intention.

The Criminal Code defines major damage as an amount exceeding RUB 1.5 million. If the acts/omissions caused major damage, the law provides liability in the form of:

1. a fine from RUB 200,000 to 500,000;
2. withholding of salary or other income for a period from one to three years;
3. imprisonment for up to six years with a fine of up to RUB 200,000; or
4. withholding of salary or other income for a period of up to 18 months.

Introduction

Nowadays, the question of management liability of companies in Russia is highly relevant. This is connected with the close attention paid by the State to the commercial activities of legal entities having managers in charge. The managerтЂ‰s right to make decisions on behalf of a company and to give obligatory instructions to employees makes this person liable for everything that happens in his company.

Russian legislation contains many rules under which the Chief Executive Officer and other managers may be prosecuted for deliberate insolvency. The rules are distributed throughout various statutes. The basic laws setting out the legal framework for management liability in Russia are: the Civil Code of the Russian Federation (hereinafter - the Civil Code), the Criminal Code of the Russian Federation (hereinafter - the Criminal Code), the Code of Administrative Violations (hereinafter - KoAP), the Federal Law тЂ€On Insolvency (Bankruptcy)тЂ‰ (hereinafter - Federal Law on Bankruptcy), the Federal Law тЂ€On Limited Liability CompaniesтЂ‰ (hereinafter - Federal Law on OOO) and the Federal Law тЂ€On Joint Stock CompaniesтЂ‰ (hereinafter - Federal Law on AO).

Russian legislation provides the following types of management and/or founders of legal entities liability for deliberate bankruptcy: civil, administrative and criminal liability.

Issues of administrative and criminal liability by founders and management have become real problems. Matters relating to administrative and criminal proceedings, especially by the management of certain companies, are currently widely discussed in the media.

It is impossible for a companyтЂ‰s management to ignore the possibility of administrative or criminal prosecution. Yet company management and founders who often consider themselves as being safe have a not liability that is very real and not at all illusory.

All types of liabilities for deliberate bankruptcy are discussed in this article, using the court practice of the highest judicial bodies of the Russian Federation.

As a general rule, the founder of a legal entity or owner of its assets is not liable for the obligations of a legal entity and a legal entity is not liable for the obligations of the founder or owner, with the exception of cases specified by the Civil Code or by the foundation documents of the legal entity (Article 56(3) para. 1 of the Civil Code).

However, the liability of a founder or owner of a legal entity may occur in the case of bankruptcy of the company. The procedure, conditions and regulations of all three types of liability for deliberate bankruptcy are discussed below.

Civil Liability

Presence of Guilt in the Form of Direct Intent According to Article 56(3) para. 2 of the Civil Code, Article 3 of the Federal Law on OOO, Article 3 of the Federal Law on AO and Article 10 of the Federal Law on Bankruptcy, if the insolvency/bankruptcy of a legal entity is caused by the founders, by the owner of the assets of a legal entity or by other persons who have the right to give binding instructions to this legal entity or in some other manner have the capacity to determine its acts in the event of insufficiency of the assets of the legal entity, subsidiary liability for its obligations may be placed upon such persons.

The presence of guilt in the form of direct intent is prerequisite to liability. Bankruptcy of the company is considered to be caused by the acts/omissions of its founders or shareholders or other persons who have the right to give binding instructions to this legal entity or in some other way have the capacity to determine its acts, only if they used this right knowing that their acts would lead to bankruptcy. The facts affirming the foundersтЂ‰ or shareholdersтЂ‰ guilt can only be ascertained during the bankruptcy proceedings of the legal entity.

Analysis shows a person can be deemed to have subsidiary liability if the following conditions can be ascertained:
1. the person has the right to give binding instructions to the debtor;
2. the personтЂ‰s acts demonstrate the use of the right to give binding instructions;
3. if there is a cause-and-effect relation between the wrongful acts/omissions of the person and their consequences - i.e., declaring the debtor insolvent;
4. if the debtor lacks the assets to make payments to creditors.

The cause-and-effect relation between the wrongful acts (omissions)

A company founderтЂ‰s guilt of deliberate bankruptcy must be proven and evaluated by the court during bankruptcy proceedings.

The institution of criminal proceedings against a defendant, which starts in the form of a statement of deliberate bankruptcy, is evidence of the personтЂ‰s guilt.

According to Resolution of Plenum of Supreme Court of the Russian Federation No. 6, Plenum of High Arbitrage Court of the Russian Federation No. 8 of 1 July 1996: тЂ€On some issues relating to the application of the first part of the Civil Code of the Russian FederationтЂ‰ the requirements for persons who bear subsidiary liability may be claimed only by the external manager for the inclusion of recovered amounts in the assets of the debtor and for the creditorsтЂ‰ settlement of the claims.

Proof of fulfilment or otherwise of acts resulting in deliberate bankruptcy

Agreements under which the assets of company are sold are often used by the courts to prove the fulfillment or otherwise of acts resulting in deliberate bankruptcy.

According to Article 129(5) of the Federal Law on Bankruptcy, the competitive manager (an arbitration administrator who is appointed by an Arbitrage Court to carry out the competitive procedure, a part of bankruptcy proceedings that has as its the main purpose the proportionate recovery of creditor demands) determines which third parties have subsidiary liability for the obligations of the debtor under Russian Federation legislation.

Claim filing and jurisdiction on bankruptcy proceedings

The prosecution on subsidiary liability of persons causing the bankruptcy of the company starts no earlier than the introduction of the competitive procedure, i.e., after the court renders a guilty verdict in the case of deliberate bankruptcy. Until completion of the competitive procedure, only the competitive manager has the right to start prosecution proceedings. Creditors may apply to the court on subsidiary liability of the management only after the completion of the competitive procedure, if the competitive manager has not already started this action.

In general, ordinary jurisdictional courts hear cases of criminal liability (separately or together with administrative and civil liability). Arbitrazh Courts hear cases related to civil and administrative liability of the type under discussion here.

Federal Arbitrage Court (FAS) of West-Siberian District provided in its Resolution Nos. F04/4178- 1211/A46-2003, F04/4177-1210/A46-2003, F04/4175- 1214/A46-2003, F04/4174-1212/A46-2003 of 25 August 2003 that cases on the subsidiary liability of the directors of insolvent debtors are not relevant to Arbitrazh Court examination.

A competitive manager brought an action before the Court against the director of the debtor concerning his subsidiary liability, as the latter disposed of assets without any equivalent implied consideration. Despite the fact that the manager was a person (or legal entity), the stated case was considered by the Arbitrage Court of the Arkhangelsk region, FAS of North-west District (FAS of Northwestern District Resolution No. A05-13914/03-23 of 1 August 2004). Similar decisions were taken by FAS of Moscow District N KGA40/ 23-04 of 11 February 2004, FAS of Central District N A23-2210/03G-17-123 of 7 December 2004; FAS of North-western District N A13-7518/02-10 of 6 March 2003.

Moscow City Court Resolution No. 33-10268 of 30 April 2009 is an example of the existing practice of ordinary jurisdictional courts. The arbitration administrator (a person who is appointed by an Arbitrage Court to carry out bankruptcy proceedings and other objectives provided by law) proved a cause-and-effect relationship between the acts of the manager and the emergence of a tax debt, and as a consequence declared the bankruptcy of the legal entity. The owner and Chief Executive Officer of the company had subsidiary liability and the Court decided to fine the manager personally the tax debt of RUB 15 million.

Court practice demonstrates that there are a small number of cases that made managers of insolvent debtors criminally liable for deliberate bankruptcy.

Administrative and Criminal Liability

Resolution No. 855 of the Government of the Russian Federation of 27 December 2004 provides the temporary rules for an arbitration administrator to check elements of fictitious and deliberate bankruptcy. During the bankruptcy proceedings, the arbitration administrator should examine:

1. the foundation documents of the debtor;
2. the financial accounts of the debtor;
3. agreements under which the sale or acquisition of debtor assets, the restructuring of assets and any increase or decrease in accounts payable were made, and other documents concerning the financial and economic activities of the debtor;
4. documents containing information about the management bodies of the debtor, as well as information on persons who have the right to give binding instructions to the legal entity or in some other manner have the capacity to determine its activities;
5. the list of the debtorтЂ‰s assets at the date of application for declaring the debtor insolvent (bankrupt);
6. the list of debtors together with an indication of the accounts receivable for each debtor;
7. a certificate of indebtedness of budgets at all levels and extra-budgetary funds indicating separately the amount of the main debt, fines, penalties and other financial (economic) sanctions;
8. the list of creditors together with the indication of the amount of the main debt, fines, penalties and other financial (economic) sanctions for improper fulfillment of the obligations to each creditor and other records of actions regulating the debtorтЂ‰s activity.

The process of identifying deliberate bankruptcy is carried out in two stages. The first analyses the values and dynamics of the coefficients that characterise the solvency of the debtor.

If it is established that there is substantial deterioration by two or more coefficients in the first stage, the second phase identifies the elements of deliberate bankruptcy, which involves analysis of the debtorтЂ‰s transactions and the actions of the managing debtor bodies over the monitoring period which could be the cause of this deterioration.

The main difference between virtual and deliberate bankruptcy is the possibility of determining the elements of the bankruptcy. The determination of fictitious bankruptcy elements is carried out in the event of institution of bankruptcy proceedings by application of a debtor. The features of deliberate bankruptcy can be identified during the period preceding the initiation of bankruptcy and during bankruptcy proceedings.

Administrative liability

Administrative liability is regulated by number of articles of KoAP for fictitious and deliberate bankruptcy.

Article 14.12(2) KoAP describes deliberate bankruptcy as the performance of acts/omissions by a director or founder of a legal entity that clearly entail the failure of that legal entity to fully satisfy the creditorsтЂ‰ claims to monetary obligations and/or to fulfil the obligation to pay mandatory charges, providing these acts/omissions do not include a criminal element.

The law sanctions liability for these acts as a penalty in the form of an administrative fine on officials of between RUB 5,000 and 10,000 or disqualification for a period of one to three years.

Constitutional Court Order No. 122-O of 21 April 2005 gives the possibility of release of the offender from the administrative liability for lack of significance of an administrative offence. If the administrative offence is insignificant and did not cause and could not have caused losses to the debtor, the court usually decides not to punish the offender or to exempt him from administrative liability and only give a reprimand. The insignificant administrative offence is an act/omission that formally contains elements of administrative violations but does not constitute an essential breach of legislation.

Criminal Liability

The Criminal Code provides formal elements of a crime committed before and during bankruptcy proceedings.

Several articles of the Criminal Code under which the manager has liability directly determine the guilt of a person causing the bankruptcy of a company: Art. 195 тЂ€Misconduct during bankruptcyтЂ‰, Art. 196 тЂ€Deliberate bankruptcyтЂ‰ and Art. 197 тЂ€Fictitious bankruptcyтЂ‰.

Deliberate bankruptcy under criminal legislation (Art. 196 Criminal Code) has the same meaning as administrative legislation - the performance of acts/omissions of a director or founder of a legal entity that clearly entails the failure of that legal person to fully satisfy the creditorsтЂ‰ claims to monetary obligations and/or to fulfil the obligation to pay mandatory charges.

Criminal liability results if the bankruptcy of the legal entity does not occur as a result of objective economic conditions but due to the deliberate acts of perpetrators. The crime is deemed to have been committed by managers or founders of the legal entity. Such a crime is committed with deliberate intention.

Evidence in criminal proceedings evaluated in accordance with the requirements of the law for the purposes of relevance and admissibility.

If the acts/omissions caused major damage, the law provides liability in the form of:

1. a fine from RUB 200,000 to 500,000;
2. withholding of salary or other income for a period from one to three years;
3. imprisonment for up to six years with a fine of up to RUB 200,000; or
4. withholding of salary or other income for the period up to 18 months thereof (Article 196 of the Criminal Code).

The Criminal Code defines major damage as an amount exceeding RUB 1.5 million.

A prerequisite for criminal prosecution under Article 196 of the Criminal Code is action by the manager leading to bankruptcy of the debtor. Also required is proof that the bankruptcy occurred because of the intentional acts of a company executive and not because of normal economic activities.

The institution of criminal or administrative proceedings against management is rare. Nevertheless, cases do occur.

For example, according to a Decision of the Supreme Court of the Russian Federation, Mr P was convicted according to Art. 196 of the Criminal Code and sentenced to two yearsтЂ‰ imprisonment, and according to Art. 201(2) of the Criminal Code (тЂ€Abuse of powerтЂ‰) to 18 monthsтЂ‰ imprisonment.

Mr P, as a person performing management functions in a company, was convicted for using his authority against the legitimate interests of the company for the purposes of deriving benefits and advantages for himself and for the willful creation of circumstances leading to the bankruptcy of the company.

Mr P, being the chief executive officer of OAO, had concluded several deals for the purpose of bankrupting OAO, which indeed led to the company becoming bankrupt and its liquidation as a legal entity. These deals can be divided into two groups. The first relates to the creation of payable accounts with regard to the realisation of the main production of OAO. The second relates to the increased likelihood of bankruptcy of OAO by withdrawing the main production assets from the list of company assets. As a result of such deals, OAO was declared bankrupt.

The courtтЂ‰s declaration of Mr PтЂ‰s guilt correspond with the case material and was confirmed by the evidence given in court. Arguments on Mr PтЂ‰s lack of intent to commit the crime were disproved by the evidence: profit and loss accounts, the balance sheet of the company, technical passports of real estate objects, the certificate of the arbitration administrator, the conclusions of accounting and construction experts and of economic experts on the market value of equipment and assets, the act of documentary revision, testimonies of witnesses and victims and copies of asset purchase and sale agreements.

The court correctly determined that Mr P should have acted in the interests of the company. The OAO foundation documents prove the liability of the director for damage caused by the use of his rights not in the interests of the organisation. The deals were concluded by Mr P and virtually the same third parties in each case within a short period of time at prices obviously lower than market prices, contrary to the statutory objectives and interests of OAO which ultimately led to the bankruptcy of the enterprise and damage to its shareholders.

According to the Moscow City Court Decision No. 22-5473 of 24 May 2006, Mr M was convicted by Savelovskiy District Court for attempted deliberate bankruptcy, i.e., the wilful creation of circumstances that might lead to bankruptcy committed by the head of a company in his own personal interests and that of others causing serious damage. The defendant Mr M in his appeal asked the Court to reverse its judgment and to order a retrial because the Court incorrectly categorised his acts as an attempt to cause deliberate bankruptcy. The Court stated in its decision that the company could be harmed by his actions and therefore the Court had to rely on the evidence.

Contrary to the defendantтЂ‰s allegations in the appeal, the Court decision describes evidence of Mr MтЂ‰s guilt, including the testimony of the companyтЂ‰s representative of falsification by Mr M of contractual relationships for the purposes of creation of a fictitious debt and the subsequent bankruptcy, and similar testimonies from the chief accountant and other accountants. However, the company was financially stable and did not enter into bankruptcy proceedings.

Savelovskiy District Court decision with respect to Mr MтЂ‰s guilt was unchanged and his appeal remains open.