Russias March to a Market Economy Assisted by New Bankruptcy Law

Russias March to a Market Economy Assisted by New Bankruptcy Law

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In terms of laws governing economic activity—commercial, property and business law—Russia is quickly joining the industrialized nations of the world. In a burst of market economy enthusiasm, coupled with a dose of market economy reality, the Russian Duma has passed and President Boris Yeltsin has approved a raft of new economic laws, including those governing corporations, securities, partnerships and limited liability companies, banking, intellectual property, real property and commercial transactions.

One such new law establishes a map for Russia to reorganize its many failing enterprises and liq-uidate, in an orderly and fair fashion, its many failed busi-nesses. Effective March 1 this year, Russia’s new Federal Law on Insolvency ("Federal Law") fundamentally and substantially revamped the entire insolvency regime present in Russia, since passage of its predecessor, the confusing and ineffectual 1992 Law on Insolvency of Enterprises. Fortunately and inevitably, this new Federal Law will establish a more useful, coherent, logical, effective and successful insolvency procedure for Russia’s fledgling market economy.

The Federal Law is the product of three elements: trial and error under the 1992 Insolvency Law; careful study and scholarship by many of Russia’s finest legal minds; blending characteristics of other western insolvency laws with traditional notions of Russian legal culture and tradition. Generally, the Federal Law appears to provide a workable, balanced and flexible blueprint for law-based reorganizations of failing enterprises and orderly liquidations of failed businesses.

The Federal Law provides that business entities and individuals (both entrepreneurs and consumers—yes consumers!) may qualify for, or be subject to, insolvency proceedings. Those proceedings may be initiated voluntarily by the debtor, or involuntarily by any creditors or the public prosecutor. Regardless of which type of insolvency proceeding is requested by or imposed on the debtor, the Arbitration Court makes the final determination.

It is clear...that the Russians have taken one great step to implementing a new market economy under the rule of law.

The Arbitration Court is the commercial court of Russia with exclusive jurisdiction over commercial, property and business disputes, as well as all insolvency cases. Other than constitutional questions, the Arbitration Court (often called the Arbitrazh Court), with its approximately 2,000 judges, serves as an independent and equal judicial body. The term includes all trial and appeals courts, including the Supreme Arbitration Court, which is the final court of appeal for commercial, property, business and insolvency issues (collectively referred to as "Court" herein).

Indeed, the Arbitration Court retains exclusive jurisdiction over all insolvency cases and must approve virtually all major acts and bankruptcy decisions made in the course of a case.

The framework of the Federal Law, in its most simple terms, is basically a three-step process:

1) An application for a bankruptcy proceeding is filed with the Arbitration Court. The Court may accept the application and will immediately initiate an Observation Proceeding. This Proceeding allows the creditors and the Court to evaluate the proposed debtor’s finances and determine whether to declare the debtor bankrupt and begin a reorganization or liquidation procedure.

2) The Court can declare a proposed debtor bankrupt and either begin a reorganization procedure—External Managementor begin a liquidation procedure—Competitive Proceedings. Alternatively, the Court can declare the proposed debtor not bankrupt and immediately terminate the application process.

3) The Court will supervise and monitor the selected course of action—the External Management or Competitive Proceedings—and, if properly concluded, the Court will close the case.

The new Federal Law has many features borrowed from the laws of Europe and North America, but it is fundamentally a Russian creation with its own characteristics. Some of the more important or interesting aspects of the law include the following:

• Reorganizations—called External Management—are given ample oppor-tunity to succeed but are on a fast track. In all reorganizations, a trustee—an External Arbitration Manager—is appointed by the Court to assume and undertake all of the debtor’s management authority and respon-sibilities. Moreover, the Arbitration Manager is obligated to evaluate the business operations and assets of the debtor, formulate a plan of reorganization, submit that plan to the creditors and, if appropriate, submit it to the Court for final approval.

• As an alternative to the formal reorganization procedure of External Management, debtors and creditors are entitled to enter into an Amicable Agreement to cure or compromise a debtor’s financial defaults and resolve debtor’s creditor disputes. This option is available to debtors and creditors at any time during any bankruptcy procedure, reorganizations and liquidations alike. Except for secured creditors, unanimous creditor support is not required.

Arbitration Managers, which serve as and hold authority similar to trustees, consist of persons appointed by the Arbitration Court to conduct bank-ruptcy procedures and exercise other powers over the debtor in all reorganizations and liquidations. They are to be trained, qualified, licensed and monitored by the Russian Federal Service on Insolvency and Financial Rehabilitation. Their appointment is always made by the Court, but with advice of the Creditors Committee.

• Creditors are represented by a Creditors Meeting, consisting of all qualifying creditors, and a Creditors Committee, which is selected by and acts in the stead of, the larger Creditors Meeting. Creditors have substantial and, in certain circumstances, decisive authority in reorganizations and liquidations.

• Officers and management of business enterprises have "incentives" to file a voluntary bankruptcy in a timely manner. Their failure to do so may result in criminal penalties, personal liability for the debtor’s business debt, and disqualification from serving as a business proprietor or manager in the future.

• A debtor must first "qualify" to be declared bankrupt by the Court and, if "qualified," is then subject to Court reorganization or liquidation pro-ceedings. For an individual, the "test" for "qualifying" as bankrupt and then being subjected to reorganization or liquidation, is failure to pay debts for a period of three months plus having a deficit balance sheet. For a business entity, the "test" is simply the debtor’s failure to pay its debts within three months after they become due.

Arbitration Managers, or trustees, are empowered with much of the same rights and authority as those granted to a trustee in bankruptcy. They may reject executory contracts, contest creditors’ claims, operate the business in the ordinary course, sell selected assets or all of the enterprise if necessary, and avoid preferential-type and fraudulent transfers.

• Priority creditor claims, after payment of expenses of the estate, are, first, to claims on account of "harm to life or health;" second, wages, severance pay and royalties; third, secured creditor claims; fourth, taxes and other government obligations; and fifth, all other unsecured creditors.

• Secured creditors do not have a right to recover their claim as against the property they hold as collateral for credit extended. Rather, their claim is satisfied from the whole body of the estate’s assets, as a third priority, and this is not, thus, a conventional secured claim with which we are accustomed.

• The concept of a bankruptcy estate and estate property is preserved, but individuals are entitled to keep certain exempt, or excepted, property as fixed by the Federal Law.

• The concepts of "conflicts of interest" and "appearances of impropriety" are embodied in the Russian Federal Law. "Interested persons" cannot serve as the Arbitration Managers; they are subject to avoidance actions; they cannot be involved in certain sales or transfers of a debtor’s assets.

• There are criminal penalties for "fictitious" and "deliberate" bankruptcy cases. Thus, contrived or manufactured insolvency situations are subject to criminal penalties.

The new Federal Law is a marked improvement over the old law and a promising beginning to a new procedure for insolvency cases. This law has all the tools necessary to implement a system for successfully reorganizing failing enterprises and liquidating, in an orderly and fair manner, failed businesses.

Over time and with more experience, there inevitably will be some modifications and refinements to the law. As it seems with all bankruptcy laws, they are constantly being improved to meet new or changing economic circumstances. The Russians are no different.

It is clear, however, that the Russians have taken one great step to implementing a new market economy under the rule of law.

Journal Date: 
Monday, June 1, 1998