One for All and All for One: Explanatory Statements of the Supreme Court on the Matters of Subsidiary Liability of People with Significant Control

At the end of the passing 2017 year, the Supreme Court of the Russian Federation held a plenary session and adopted Resolution of the Supreme Court of the Russian Federation Plenum No. 53 dated December 21, 2017 on the matters of subsidiary liability for people with significant control over the debtor upon bankruptcy.

In fact, it is the first and only Resolution of the Supreme Court of the Russian Federation Plenum on the matters of subsidiary liability for people with significant control over the debtor.

Given the development of an ambiguous legal practice and recent changes in the legislation on bankruptcy (regarding subsidiary liability for people with significant control), this resolution is particularly significant and long-awaited.

This article will cover key aspects and conclusions made by the Supreme Court in this resolution.

People with significant control over the debtor

Who shall be qualified as a person with significant control?

Pursuant to the general rule, a person shall be qualified as a person with significant control over the debtor provided they have an actual possibility to give binding instructions to the debtor or otherwise determine its actions.

The actual control is assumed (presumed until proven otherwise) in cases when a person is a director or a founder (member) holding more than 50% of the registered capital stock (shares).

However, one may have an actual control over the debtor regardless of technical signs of affiliation or their absence (through kinship or affinity with members of debtor’s governing boards, direct or indirect participation in capital or management, etc.).

Technicalities (membership in governing boards, participation in the registered capital or kinship/affinity with the said persons) are not enough to be qualified as a person with significant control. The court shall determine the level of involvement in the control process over the debtor of the person subject to subsidiary liability by checking the significance of its influence on the adoption of material business decisions regarding debtor’s activities.

Particularly, a person shall be qualified as a person with significant control over the debtor, if deals which changed the economic and/or legal status of the debtor had been made under the influence of this person.

Besides, a person which profited from illegal behavior, including misbehavior, of the debtor’s director may be declared a person with significant control. According to explanatory statements of the Supreme Court, such benefit involves the increase (saving) of assets. For instance, this may be the third party which acquired debtor’s material asset (including via a chain of consecutive deals) which got out of the debtor’s possession under the deal made by the debtor’s director to the detriment of the company under its direction and its creditors (for example, on intentionally unbeneficial conditions or with a person unable to perform its obligations (“short-lived company”, etc.) or using documents that do not reflect actual business activities, etc.). Pursuant to the general rule, such beneficiary bears subsidiary liability with the debtor’s director. Counter to the said presumption, a person subject to this liability shall be entitled to prove its good faith by confirming fee-based acquisition of the debtor’s asset under the conditions typical for similar deals.

It’s also assumed that a beneficiary shall be considered a person with significant control when it gained significant benefits from the business administration that is aimed at the reallocation (including via invalid documents) of the total income from the performance of these activities by persons with common interest (for example, united production and/or distribution cycle) for the benefit of these persons with a simultaneous accumulation of the main debt load on the debtor’s side. However, the beneficiary may prove its good faith (particularly, the fact that its profit-gaining transactions are recorded in accordance with their actual economic rationale, and that received benefits are justified by economic reasons).

Moreover, the list above is not complete.

Which period is taken into account when determining a person with significant control?

For the application purposes of special legal provisions on subsidiary liability, pursuant to the general rule, one shall consider the control that took place during the period preceding the actual appearance of bankruptcy signs, whether the actual financial situation of the debtor was disclosed or not, i.e. one shall consider a 3-year period preceding the moment when the debtor was unable to fully satisfy creditors’ demands.

Meanwhile, the said legal provisions do not exclude the possibility of holding a person with significant control liable for actions performed during the said 3-year period, for example, liabilities set out by the legislation on legal entities.

When powers of the sole executive body are transferred to a managing company?

The Supreme Court explains that in case the debtor’s director is a managing company, both the managing company and its director are supposed to be people with significant control over the debtor with joint subsidiary liability pursuant to the general rule, unless proven otherwise.

Will the issue of the power-of-attorney save from qualifying as a person with significant control?

A director that holds membership in legal entity boards, but performs no actual management (hereinafter, the nominal director) and, for example, fully delegated the management to another person under the power-of-attorney or made key decisions by order or upon express consent from a third party with no relevant powers (actual director), does not lose the status of a person with significant control, as such behavior does not mean losing its influence on the debtor and does not relieve the nominal director from performing obligations on choosing attorneys and controlling their actions (omission), as well as providing proper management of the legal entity.

In this case pursuant to the general rule, both nominal and actual directors shall bear joint subsidiary liability.

Possibility of mitigating the subsidiary liability?

The burden of the nominal director’s subsidiary liability may be mitigated, if he discloses information which was unavailable to independent economic agents, and therefore, helps to determine the actual director and/or the debtor’s property or the actual director’s property hidden by them, due to which creditors’ demands may be satisfied.

Upon the matter consideration on the nominal director’s subsidiary liability, the court has to take into account its assistance in information disclosure that ensured the restoration of violated creditors’ rights and reimbursement of their property losses.

In case of the mitigation of the nominal director’s subsidiary liability, the actual director shall bear the full subsidiary liability. The nominal director shall be jointly and severally liable with the actual director to the non-mitigated extent.

Subsidiary liability for the failure to file (untimely filing) of the debtor’s application on its bankruptcy

Who is held liable for the failure to file a self-bankruptcy application to court in case of several directors?

If the debtor’s incorporation documents state that several persons (directors) shall be given powers to act jointly or independently on behalf of the legal entity, pursuant to the general rule, the said persons shall jointly and severally bear the subsidiary liability.

The incorporation documents shall not give powers to appeal to court with the debtor’s application on its bankruptcy only to one of its directors.

Upon which moment the director is obliged to appeal to court with the debtor’s application on self-bankruptcy?

The director’s obligation to appeal to court with the debtor’s application on its bankruptcy shall arise at the moment when a fair and reasonable director in similar circumstances pursuant to the basic management practice, considering the scope of debtor’s activities, would objectively determine one of the conditions stipulated by the law (insolvency, property insufficiency, etc.).

If the director proves that the occurrence of the said circumstances itself bears no evidence of the objective bankruptcy, and that despite temporary financial difficulties, he expected in good faith to overcome them within a reasonable time and made best efforts to achieve this result by fulfilling an economically reasonable plan, such director may be relieved from subsidiary liability for the period within which the fulfillment of his plan would be qualified as reasonable by an ordinary director in similar circumstances.

Is it required to prove a cause-and-effect link between the failure to file an application and the failure to satisfy creditors’ demands?

It’s presumed that there is a cause-and-effect link between the failure to file an application on bankruptcy by the debtor’s director, liquidation committee, and the failure to satisfy creditors’ demands, obligations to which arose during the expiration of the period for filing an application on bankruptcy.

Is it possible to hold the debtor’s founder subsidiary liable for the failure to file an application on self-bankruptcy by the debtor’s director?

Upon the failure of the debtor’s director to file the debtor’s application on self-bankruptcy to court, the governing board responsible for settling the debtor’s liquidation shall make the decision to appeal to court.

The person that does not qualify as the debtor’s director, liquidator, and member of the liquidation committee may be held subsidiary liable (jointly with the director) for the failure to file (untimely filing) the debtor’s application on its bankruptcy, given the following conditions:

  • This person was a person with significant control, including through unproved presumptions on the control over the majority corporate member (sub-clause 2, clause 4, article 61.10 of the Law on Bankruptcy), on the control of the beneficiary in the illegal deal (sub-clause 3, clause 4, article 61.10 of the Law on Bankruptcy). etc.;
  • It could not know of the debtor’s situation which resulted in its director, liquidation committee having an obligation to appeal to court with an application on bankruptcy, and on the failure to fulfill this obligation on their part;
  • This person had powers to call the meeting of the debtor’s collegial board responsible for the corporate decision on liquidation, or had powers to make the above decision on its own;
  • It failed to properly perform actions aimed at calling the meeting of the debtor’s collegial board to resolve on the matters of filing an application on bankruptcy to court or to make such a decision.

Who bears subsidiary liability upon the consequent change of directors that fail to perform their obligation on the appeal to court?

If several consequent directors fail their obligation to file an application on self-bankruptcy to court, the first of them shall bear subsidiary liability for the obligations arising during the time from the expiration of the monthly period set out for filing of such an application until the initiation of bankruptcy proceedings, and further directors – from the expiration of the month-extended reasonable period required to determine relevant circumstances being new directors as they are until the initiation of bankruptcy proceedings. Meanwhile, they are jointly and severally liable for any debtor’s obligations arising during liability periods for several directors simultaneously.

Subsidiary liability for the failure to fully settle creditors’ demands

Which actions of a person with significant control shall be considered as leading to the failure to settle creditors’ demands?

The point at issue is such actions (omission) of a person with significant control which caused the debtor’s bankruptcy, i.e. such actions, the absence of which would not lead to the objective bankruptcy (particularly, making key decisions violating good faith principles, including consent, making or approval of deals on intentionally unbeneficial conditions or with a person unable to perform its obligations (“short-lived company”, etc.), giving instructions for making express profit-losing transactions, appointing managers that will clearly act against the interests of the managed company, creation and maintenance of the debtor’s management system which is aimed at the systematic profiting of the third party to the damage of the debtor and its creditors, etc.)

The court shall estimate the effect of actions (omission) of a person with significant control on the debtor’s situation by checking a cause-and-effect link between its actions (omission) and the occurrence of the actual objective bankruptcy.

However, as the legal entity activities are influenced by numerous deals and other transactions, pursuant to the general rule, the latest deal (transaction) initiated by a person with significant control, which critically changed the preexisting unfavorable financial state, i.e. appearance of objective bankruptcy signs, may not be considered the sole prerequisite for the bankruptcy.

Such actions also include those that took place after the objective bankruptcy and significantly aggravated the debtor’s financial state. Given the abovementioned, pursuant to the general rule, a person with significant control that created conditions for further significant disproportion growth between the asset cost and its obligations.

When a person with significant control is not subject to subsidiary liability?

A person with significant control over the debtor is not subject to subsidiary liability in case its actions (omission) causing the adverse effect did not go beyond the usual business risk and did not aim at the violation of rights and legal interests of the civil community of creditors (the so-called rule of business decision protection).

Besides, when proving absence of grounds for subsidiary liability, a person with significant control is entitled to refer to the fact that bankruptcy is caused by solely external factors (unfavorable market situation, financial crisis, significant changes of business conditions, emergencies, acts of God, other events, etc.).

In case the bankruptcy resulted from actions (omission) of a person with significant control, but besides the said actions (omission) some external factors (for example, illegal withdrawal of debtor’s assets under the influence of a person with significant control and simultaneous damage of debtor’s products by floods) also caused the increase of debt liabilities, the subsidiary liability may be mitigated pursuant to the second paragraph, clause 11, article 61.11 of the Law on Bankruptcy.

How do general procedures on indemnification (article 53.1 of the Civil Code of the Russian Federation) differentiate from special procedures on subsidiary liability?

According to the Supreme Court, in each particular case courts shall consider the significance of the adverse influence of a person with significant control on the debtor’s activities by checking the change in the debtor’s financial state under such influence, and tendencies of economic results typical for the debtor after such influence.

In case violations by a person with significant control were the direct cause of bankruptcy, provisions on subsidiary liability shall be applied, and pursuant to the general rule, its total amount shall be determined in accordance with the Law on Bankruptcy.

In case the damage caused by persons with significant control specified in article 53.1 of the Civil Code of the Russian Federation were reasonably expected not to cause the debtor’s objective bankruptcy, such persons shall reimburse for any caused losses in the amount determined in accordance with article 15, 393 of the Civil Code of the Russian Federation.

How do several persons with significant control share their liability?

Pursuant to the general rule, if several persons with significant control acted jointly, they shall jointly bear subsidiary liability for causing the bankruptcy. When qualifying actions of persons with significant control over the debtor as joint, one may consider coherence, mutual coordination and orientation of these actions towards common goals, i.e. one may take into account engagement in any form, including joint participation, collusion, etc. Unless proven otherwise, it is presumed that actions of several affiliated persons with significant control are joint.

If several persons with significant control over the debtor acted independently and such independent actions were sufficient to cause the debtor’s objective bankruptcy, the said persons shall also jointly bear subsidiary liability.

If several persons with significant control over the debtor acted independently and such independent actions were insufficient to cause the debtor’s objective bankruptcy, but in total their actions caused such bankruptcy, such persons shall bear subsidiary liability on a pro rata basis. In this case the court shall divide the total subsidiary liability by determining the part of each person with significant control proportionate to the damage caused. Upon the failure to determine the damage caused due to particular transactions under the influence of any person, the part of each person with significant control may be determined proportionate to the period of their actual control over the debtor.

What are the conditions of holding the debtor’s director subsidiary liable for the failure to submit documents to the official receiver?

When applying presumptions regarding the submission failure, concealment, loss or misrepresentation of documents for settlements of disputes on subsidiary liability, one shall consider the following.

The applicant shall provide explanatory statements to the court on the effect the document absence (absence of full information or misrepresentation) had on bankruptcy proceedings.

The person subject to liability shall be entitled to deny the said presumptions by proving that discrepancies in the documents submitted to the receiver caused no significant hindrance to bankruptcy proceedings, or by proving its absence of fault in the submission failure, improper document keeping, particularly, by confirming that it took all reasonable efforts to fulfill its obligations on keeping, maintenance and submission of documents with all due care and diligence.

The significant hindrances to bankruptcy proceedings shall mean inter alia:

  • The failure to determine the whole range of persons with significant control over the debtor, its major counterparties, and:
  • The failure to determine debtor’s core assets and to identify them;
  • The failure to determine deals and their terms during the period of suspicion, which prevented from analyzing these deals and resolving on the necessity to impeach them in order to increase bankruptcy assets;
  • The failure to estimate the content of resolutions adopted by the debtor’s boards, which prevented from analyzing these resolutions for the purpose of discovering their damage to the debtor and creditors and revealing the potential possibility of loss recovery from the members of these boards.

In case of illegal actions by several consequent directors regarding keeping, maintenance and restoration of documents, it is presumed that their actions were sufficient to cause the debtor’s objective bankruptcy.

Pursuant to the general rule, persons that are not qualified as persons with significant control, but are responsible for keeping and maintaining relevant documents (for example, chief accountant) shall jointly with the former director bear subsidiary liability for causing the bankruptcy as joined parties, provided it is proved that they acted by order of the former director or performed joint actions therewith, which caused the destruction, concealment of documents or misrepresentation of data therein.

Conclusion

This article covers the most significant key explanatory statements of the Supreme Court on the matter under consideration. However, the Plenum Resolution contains other explanatory statements on interesting and urgent issues (the rightholder to file an application on subsidiary liability, application filing period, choice of cause of action/applications and other procedural aspects).

The adoption of the Plenum Resolution by the Supreme Court was logical, given the increased practice and recent changes in the legislation on bankruptcy, which specified procedures of subsidiary liability imposed on persons with significant control. Introduced changes to the legislation on bankruptcy supported by explanatory statements of the Supreme Court are supposed to encourage transparent business practices, decrease the number of short-lived companies and nominal service involved in business processes, and to ensure a more responsible approach to company management.

On the other side, adopted changes nearly eliminate the distinction between company assets and member/founder assets, which undoubtedly, require diligence and caution when making significant business decisions.

Alexey Oskin

Deputy Director

Tax and Legal Practice

Korpus Prava (Russia)

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