The Reform of the Civil Code: Some Reservations

The Ministry of Justice has prepared ‘the agreed’ draft of the amendments to the Civil Code. However, the following issues have not been resolved: (i) whether to increase the minimum share capital (for limited liability companies, up to 300,000 roubles or app. $10,000 and for open joint stock companies, up to 1 million roubles or $33,000); and (ii) whether offshore companies operating in Russia must disclose their beneficiaries.

It is not surprising that these issues are still unresolved in the ‘agreed’ project. They are the cornerstone of the reform. Moreover, the reaction of the legal community to these suggestions has been extremely negative, and many lawyers have called for business and for all legal community to speak out against these proposals.

It is not surprising that these issues are still unresolved in the ‘agreed’ project. They are the cornerstone of the reform. Moreover, the reaction of the legal community to these suggestions has been extremely negative, and many lawyers have called for business and for all legal community to speak out against these proposals.

It is obvious that an increase in the minimum share capital as well as the obligation for offshore companies to disclose their beneficiaries aim to fight sham companies, to increase the transparency of the Russian economy and to prevent tax evasion. The goal is good, but at what cost?

In our opinion, the increase in the minimum share capital is not an effective way to deal with sham entities. Nor is it an absolute guarantee of creditors’ rights.

Practice shows that flight-by-nights companies can be used for illegal transactions involving tens or hundreds of millions of roubles. So, the proposed restriction is unlikely to affect the activities of sham companies in any significant way. A flight-by-night company can easily increase its share capital and then, just as easily, withdraw the funds. This process can take days or, at times, hours. In other words, the idea of fighting such companies by increasing share capital is wide of the mark.

It is clear that the increase in the minimum amount of capital will affect the legitimate small and medium business. Business will have to seek additional funds to increase the share capital. And the only way they can do this is by increasing the cost of goods, services or works. Thus, the costs associated with such increase will be offset by increasing the value of goods, services and works produced by limited liability companies and / or open joint stock companies. That is, the burden will fall on consumers. It is also likely that small businesses that cannot find affordable finance to increase the capital, may decide not to do business in Russia at all.

Russia already can hardly be called a country with a favourable investment climate due to the presence of numerous obstacles, including those of legal and administrative nature. The introduction of this new rule would not facilitate access to the Russian market for foreign investors - who are not rushing to come here already - but would add difficulties.

Today, the country's leaders are taking steps to establish an international financial centre in Moscow. In addition, in light of Russia's accession to the WTO, the priority should be opening borders and removing market barriers to foreign investment. First of all, this concerns the simplicity of establishing a legal entity. Thus, the proposed step is unlikely to contribute to the inflow of foreign investments into the Russian economy.

No doubts, flight-by-night companies - or rather shady businesses that use them - are a serious problem. However, a single remedy, a single action, a single law would not work. A whole set of legal and administrative instruments is needed. Perhaps, it would be viable to revise the procedure for registration, reorganization and liquidation of companies.

Setting a flight-by-night company is not difficult largely because of excessive formalization of the procedures for the establishment of a legal entity and because of the connivance of tax authorities.

It should be noted, though, that the work here is already under way. For example, criminal responsibility for the creation of sham companies has been introduced. However, it would be advisable to introduce some form of responsibility for state officials who take a direct part in the registration of sham structures, and to improve legislation on creation of legal entities.

In particular, it would be appropriate to introduce a rule that a general director, and in some cases a participant / shareholder of a new company, must be present in person when applying for registration, reorganization and liquidation of a company; to increase time for tax audits of organizations that undergo reorganization or liquidation; to introduce the rule that the minutes of general meetings of shareholders, where matters of reorganization or liquidation of business entities are decided, must be witnessed by a notary. This can be done easily, and the effect will be much greater. Moreover, it would be right to toughen punishments for notaries, who in accordance with the law must verify the legality of the documents for creation, reorganization or liquidation of companies.

It is also clear that the registration laws must be eased for public companies whose shares are traded on stock exchanges. The purpose of such compromise is clear: a sham company will never place its shares on a stock exchange.

The requirements for placement of shares are very tight and they practically eliminate dubious companies. Moreover, in our opinion, the requirement for a CEO of a public company to attend tax authorities to carry out registration procedures would be too burdensome for large businesses, such as public companies. The presence of a general director of such company in the tax office for registration purposes is economically inefficient. Thus, it would be reasonable to establish a provision in law that would keep CEOs of public companies personally responsible for registrations done on by an authorised representative.

With regard to the duty of offshore companies operating in Russia to disclose information about beneficiaries, the matter seems no less controversial.

First of all, it is unclear how this measure can affect transparency of business in Russia. Secondly, asking offshore companies to reveal beneficiaries while information about property or assets of government officials is hidden from society is, to put it mildly, unfair. In these circumstances, business will not expose its beneficiaries but will find a way around such regulation.

Moreover, the effects of non-disclosure are not clear. What if an offshore company refuses to disclose information about its beneficiaries? Some licenses from its Russian subsidiary, or from a company where the offshore company has a share, will be withdrawn? Contracts between Russian companies and offshore entities that steadfastly refuse to make public information about their beneficiaries will be invalidated? It is not clear.

Obviously, if the above proposals are accepted, they will seriously affect the investment climate in Russia.

It is worthwhile to note that the above sanctions on Russian companies when their offshore shareholders do not disclose information about beneficiaries can violate the rights of other shareholders in these Russian companies, which are not required to disclose such information or disclosed it properly.

In addition we should mention that it is unclear how the proposed changes relate to changes in the structure of ownership of offshore companies. After all, while tracking changes in the corporate structure of a Russian company is, at least in theory, possible, tracking changes in the ownership of a company in a tax haven is, we’ll put it lightly, problematic.

In our view, if the legislator wants to increase the transparency of the Russian economy and to reverse the negative aspects of companies from tax havens taking part in it, the chosen method is ineffective and possibly harmful.

A whole set of measures is needed. In particular, the following:

(i) The notification procedure for offshore companies must be simplified. At the moment it takes at least six months to notify an offshore company about legal proceedings in Russia. In practice, there are cases when an offshore company was incorrectly notified and court had no choice but to postpone hearings for another six months so that the company was notified properly. In other words, a complicated notification procedure leads to protracted litigation. Moreover, the complicated procedure creates a huge space for all kinds of abuse. Unscrupulous litigators create offshore companies merely to drag out trails. Of course, the simplification of the procedure would entail changes international treaties which have been adopted by Russia. However, this is the case when the end justifies the means.

(ii) An offshore company must have a representative in Russia. Sometimes, offshore companies that operate in Russia are used as a window dressing with nominal secretaries and directors. There were cases when directors of offshore companies operating in Russia were not aware of the existence of any assets of these companies in Russia. Naturally, such people cannot be considered as the company’s representatives. The presence of the representative offshore companies in Russia would also help to simplify the notification procedure. Also, it should be a rule that an offshore company which does not have a representative in Russia can be notified at any address specified in the documents in respect of that company (contracts, letters, court documents which come from the offshore company) and by any available means (including e-mail).

It would also be a good idea to create a special register of such offshore companies with their contact persons, addresses, offshore companies and other details. If an offshore company fails to provide information to such registrar, it should take all the risks associated with the notification procedure regarding legal proceedings in Russia (at the company’s address stated in contracts, letters or other documents issued by the company) by any means available to the parties (including by e-mail).

These measures, in our opinion, are more efficient and would have had greater practical value. They wouldn’t scare off offshore companies from doing business in Russia, since it is obvious that the majority of the beneficiaries of offshore companies have Russian passports. These step would create clear rules of the game, the most important of which is that if you want to do business in Russia with the use of offshore companies and remain unidentified, accept all the risks associated with the use of such structures.

Muranov, Chernyakov & Partners