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7 February 2018 Supreme Court Clarifies Liability for Debtor Controlling Parties in Bankruptcy Cases

Legal update No 628

Goltsblat BLP advises that, on 21 December 2017, Russia’s Supreme Court Plenum adopted Resolution No. 53 “On Certain Issues Related to Liability for the Debtor’s Controlling Parties in Bankruptcy.” The Resolution provides important clarifications on Chapter III.2 of the Federal Law “On Insolvency (Bankruptcy)”, which has been in effect since summer 2017.

The new chapter of the Bankruptcy Law deals solely with liability of controlling parties and contains several ground-breaking developments designed to refine the secondary liability mechanism and promote its application in bankruptcy. For example, there is now a much wider range of persons that may be deemed controlling, and grounds for their liability are given in detail (see Goltsblat BLP Legal Update No. 612 of 18 September 2017).

The Resolution should remove some pressing issues triggered by the new regulation of secondary liability and steer law-enforcement practice.
We believe the following Supreme Court clarifications are the most important:

1. Exceptional mechanism and business judgement rule. The Supreme Court specifically notes that secondary liability in bankruptcy is an exceptional mechanism for restoring creditors’ infringed rights. In applying it, courts must take into account both the business entity concept and the broad discretion vested in the legal entity’s bodies for making business decisions (clause 1).

Under this principle, a person controlling the debtor may not be held liable if their actions adversely affecting the debtor do not go beyond normal business risks or seek to infringe creditors’ rights and legitimate interests (clause 18).

This important principle should help provide entrepreneurs with scope for making business decisions without automatically becoming a target for secondary liability lawsuits.

2. Nominal CEOs are also liable. Nominal CEO status does not release its holder from liability since it does not imply loss of all influence over the debtor. The novel developments to the Bankruptcy Law give nominal CEOs a chance to make a “deal with the court” (to eliminate or reduce liability by providing information about the debtor’s actual CEO and/or property); this chance, however, depends on whether such a nominal CEO has information not available to independent parties and on how much this cooperation helps pierce the corporate veil (identify a shadow director) and/or property, restore creditors’ infringed rights and indemnify their losses (clause 6).

3. A person benefiting from the debtor’s illegal or bad-faith conduct is a controlling party. This presumption applies when a person derives benefit that is material for the debtor’s business. For example, a debtor passes over a material asset in a transaction made on terms obviously unfavourable for the debtor or with a counterparty patently unable to discharge its obligation (such as a paper company). Another example is benefits derived from a common business arrangement whereby assets and liabilities are accumulated with different companies (clause 7).

4. Liability for CEO’s failure to discharge their obligation to file for bankruptcy. The Supreme Court suggests using a “good-faith and reasonable CEO” standard to address the practical challenge of determining when an obligation arises for a CEO to file the debtor’s bankruptcy petition. If the CEO proves that, in spite of temporary financial difficulties, they expected, in good faith, to overcome them within a reasonable time and made the requisite efforts to achieve this by implementing an economically justified plan, such a CEO may be released from secondary liability for the period when such implementation was reasonable (clause 9).

5. A transaction is significantly detrimental to creditors. This presumption of driving the business to bankruptcy may apply if a transaction made by or in favour of a controlling person is significant for the debtor’s business (such as major transactions in corporate law terms) and, at the same time, materially loss-making (for example, its terms are significantly worse than on the market or it becomes impossible for the debtor to continue pursuing one or more of its lines of business (clause 23).

6. Absence of documents: not a foregone conclusion? In practice, absence of some or all accounting documents has entailed secondary liability on the CEO with a high degree of probability. The Supreme Court proposes a more cautious approach, noting that the applicant should argue how the lack of documents affected the bankruptcy procedures. In turn, the CEO may be released from liability if they prove that defects in the documents they provided to the insolvency officer did not cause significant difficulties for the bankruptcy procedures, while the CEO acted reasonably and in good faith and took the requisite steps to request and restore the documents (clause 24).

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