Time to try the grounds

As the crisis deepens in Russia it becomes clear that for many the burden of debt is unbearable. Courts have already started registering an unprecedented growth in actions to recover debts. The battle for the defaulters' assets has begun.

But it will not be fought by the old rules. Terrified by the sheer number of potential bankrupts Parliament has changed the insolvency law forcing creditors to stand back.

More than just a bank.

The debt of Russian companies as seen by official statistics is $780 billion, of which $300 billion is owed to foreign companies, $450 billion is the debt to domestic banks, and $30 billion - internal bonds. The private debt to GDP ratio of around 50% is comparatively modest and by no means reached an unsustainable level. It is on the structure of the debt where gloominess feeds.

According to the chief economist of Alfa Bank, Natalia Orlova, Russian companies will have to pay around $60 billion to foreign creditors within a year. As the Russian economy shrinks it might be difficult to pay or postpone the bill.

"The government's position on Russian debt to foreign banks has been that all debt must be paid back and all agreements upheld," First Deputy Prime Minister Igor Shuvalov said to Bloomberg on March 19. Russian companies need to work with domestic banks to solve their foreign debt problems and not rely on government bailouts, he said. It means that the government expects domestic banks to absorb the debts and, ultimately, act as the national crisis manager.

Debt of the Russian companies to domestic banks, though substantial per se, is largely a short term debt. In practice banks lend money for one year and then extend it for a new period. In economical turmoil this will not necessary be the case.

As the amount of defaults is growing, according to the Central Bank of Russia on April 1 the figure has reached $17 billion, and this is just a tip of an iceberg, the banks will be forced to recover debts. But here there will be surprises.

Bankruptcy: the Russian way.

Banks normally hold security interest in the debtor's property and, therefore, can force the sale of the property and take what is due from the proceeds in priority to all other creditors. Seizure of the company's assets by the secured creditor in most cases leaves other creditors empty handed; and for them, as well as for the debtor, bankruptcy remains the only effective weapon.

As the law stands the bankruptcy procedure can be initiated relatively easily either by the debtor, or by a creditor provided that the debt in the amount $3,000 is confirmed by court and is outstanding for 3 months.

There are five distinct legal regimes for handling the insolvency of a company: supervision, financial rehabilitation, administration, winding up, and arrangements with creditors.

Bankruptcy starts from supervision, which can take 7 months. Under supervision the debtor's management bodies are not divested of their management powers. Certain transactions, however, must be approved by an interim manager appointed by court. Introduction of the supervision procedure imposes an almost total freeze on the enforcement of security rights, institution of legal proceedings, reorganisation and the winding up of the company. It also restricts a creditor's self-help remedies like set-off.

Financial rehabilitation or administration procedures can follow supervision with the view to putting a company back on its feet.

The financial rehabilitation is introduced by order of the court, approving the decision of the meeting of creditors or application by the debtor and can take as long as 2 years. Financial rehabilitation can be introduced when there is a reasonable ground that the company can repay the debts. In practice this usually means a third party guarantee. During financial rehabilitation the company's directors do not vacate their offices and the company can enjoy moratorium on enforcement of security rights and institution of legal proceeding.

Administration is close to administration in England or Chapter 11 of the American Bankruptcy Code. It starts by the court's order made upon the decision of the meeting of creditors and, like supervision, it imposes a freeze on the enforcement of security rights, institution of legal proceedings, reorganisation, and set-off. The company directors are dismissed and an external manager appointed by court takes the lead.

Winding up is an insolvency process leading to the end of the company's existence. By contrast with other regimes it does not, strictly speaking, freeze the enforcement of rights, but converts the creditor's rights of action into rights of proof for a dividend in liquidation.

The creditors and the company can reach an agreement at any stage of the bankruptcy procedure; the arrangement must be voted for by the majority of the creditors, including all secured creditors, and be approved by court.

Not a sword but a shield.

The amendments to the insolvency legislation made by laws NoNo. 296-FZ and 306-FZ, both dated 30 December 2008, introduced significant changes to the position of secured creditors. The changes to insolvency legislation can make unsecured creditors and companies in default willing to use bankruptcy procedures against secured creditors more often.

Security rights are now affected by the winding up and in a wider sense by the introduction of bankruptcy procedures in general. According to the new law only 70% of the proceeds from the sale of security comes to the secured creditor, the rest is distributed pari passu among all creditors. He may try to enforce his rights during the financial rehabilitation or the administration regimes, which is now possible, but the attempt can be easily blocked by proving that the sale of property prevents the company from getting back to life.

A secured creditor will now loose voting rights on the meeting of creditors during the financial rehabilitation or administration unless he waives the right to enforce security for the duration of the insolvency regime.

In effect the amendments to the insolvency law transform the secured creditor's rights from a sword into a shield and drag him, in somewhat bizarre way, into an arrangement with the debtor and other creditors.

Yesterday's problems.

Russians are eager to implement the most advanced ideas in insolvency. Essentially, the law here attempts, first and foremost, to facilitate arrangements with creditors with the view of business rescue where the enterprise is fundamentally sound. These efforts, however, risk sinking in the nebulousness of domestic laws.

Challenge of the insolvency law lies in its close relationship with other areas of law; it cannot be effective unless it has firm grounds in the company law, obligations, and property law. Debtors are determined to test hard how firmly the bankruptcy law is rooted, and legal actions to recover debts are followed by counterclaims aiming if not to stop recovery, but delay it.

In a growing number of cases shareholders of the security provider claim an agreement void on the basis that the corporate procedures of the company were not followed. In 2006 a minority shareholder of JSC Morros sought to set aside a security agreement between JSC Morros and Alfa Bank. The security was provided as a guarantee for the loan to a third party. Directors of the borrower had an interest in the company, security provider, and, therefore, the transaction should have had been approved by the board of JSC Morros. The bank won. It, however, had to reach the Presidium of the Supreme Arbitrazhniy Court, and the case was resolved on formal grounds as the plaintiff missed the time bar for setting aside the agreement.

Later the Supreme Court had to return to this case and ruled that a deal where there is an interest of directors can be set aside if the defendant had a constructive knowledge that the directors of the plaintiff had an interest in the transaction. The burden to prove that the defendant did not know and could not reasonably be expected to know of the interest was loaded on the defendant.

Avoidance of deals through reference to the company's internal procedures has become a signature of Russian law. It can be applied not only to transactions with interest but to a number of situations. International tribunals and foreign courts normally reject claims to set aside contracts upon such grounds, but at home ambiguity still exists and debtors can seek sympathy.

The main problem, however, is that Russian insolvency legislation has rarely been used for debt collection and almost never to facilitate the debtor's recovery. In the public view bankruptcy is seen as a tool for aggressive takeovers and a nest of corruption.

Amendments to the insolvency law introduce a series of steps to gain public confidence. Bankruptcy managers must now insure their professional liability and a special fund must be created by the organizations of bankruptcy managers to cover damages in the case of misconduct of their members. The debtor's property must be sold at an auction; and commercial courts have now jurisdiction to hear cases related to wrongdoings during the bankruptcy.

Russian bankruptcy legislation, in theory, follows the general principles of the American Bankruptcy Code or English Insolvency Act 1986. In reality it is a long and dark road with traps for anyone stepping on to it, a debtor or a creditor.

Attempts to steal a march and create an advanced insolvency regime with the purpose of business recovery can turn out a lofty dream. In the absence of transparent and relatively quick debt recovery system the business might see the return of ferocious 1990-s when debt collection operated in the legal netherworld.