Subsidiary Liability of Controlling Persons at Bankruptcy

Any company may have a moment when it is unable to meet its obligations to creditors. At bankruptcy, the most dangerous for the personal welfare of owners and business executives is the risk of bringing to subsidiary liability, stipulated by Article 10 of the Federal Law “On Insolvency (Bankruptcy)” (hereinafter , the FZ “On Bankruptcy”). This law, taking into account the new amendments that come into force on June 28, 2017, will continue to develop, providing competitive creditors and the authorized body with more instruments to collect debts.

Subsidiary liability may be imposed on persons controlling the debtor. In the context of the Russian insolvency law, a “controlling person” means any person who, in the three-year period prior to accepting the petition for the recognition of the debtor as a bankrupt, had the opportunity to influence the decisions made by the company in one way or another. Namely, it had the right to give instructions binding on the debtor or had the opportunity, by virtue of being in relations of kinship or property with the debtor, by virtue of its official position or otherwise determine the actions of the debtor, including by coercing the manager or members of the debtor’s management bodies or exerting a decisive influence on the manager or members of the debtor’s management bodies in a different way.

The notion of a “controlling person” established by the Federal Law “On Bankruptcy” is quite broad, and its definition, with a sufficient evidence basis, may include a wide range of persons – participants, shareholders, general director, its deputies, members of the board of directors, chief accountant, beneficial owner, as well as other persons. A petition for bringing these persons to subsidiary liability may be filed by a bankruptcy trustee, a bankruptcy creditor, a representative of the debtor’s employees, an employee and a former employee of the debtor or an authorized body.

Subsidiary liability itself is a civil law institution, therefore, its application shall take into account the general provisions of Chapters 25 and 59 of the Civil Code of the Russian Federation on liability for violations of obligations and on obligations as a result of causing harm in part that does not contradict the special provisions of the FZ “On Bankruptcy”.

Grounds for liability

Currently, the provisions of the Federal Law “On Bankruptcy” provide for two grounds for bringing persons controlling the debtor to subsidiary liability under its obligations:

1. Untimely submission by the company’s manager or a liquidation commission of a petition for recognition of a company as a bankrupt to an arbitration court (Article 9 and Clause 2 Article 10 of the Federal Law “On Bankruptcy”).
2. Actions (omissions) by the controlling persons as a result of which the company is declared a bankrupt (Clause 4 Article 10 of the Federal Law “On Bankruptcy”).

Failure to file a bankruptcy petition

The provisions of Article 9 of the Federal Law “On Bankruptcy” provide for the obligation of the manager of a legal entity to apply for bankruptcy in the following cases:

– Satisfaction of the claims of one creditor or several creditors leads to the impossibility of the debtor’s performance of monetary obligations or obligations to pay mandatory payments or other payments in full to other creditors.

– The debtor’s body, authorized in accordance with its constituent documents to take a decision on the liquidation of the debtor, decided to apply to the arbitration court with the debtor’s application.

– The body authorized by the owner of the property of the debtor – unitary enterprise decided to apply to the arbitration court with the debtor’s petition.

– The foreclosure of the debtor’s property will significantly complicate or make impossible the economic activity of the debtor.

– The debtor meets the criteria of insolvency and (or) criteria of insufficiency of property.

– There is a debt outstanding for more than three months due to insufficiency of monetary funds for severance payments, wages and other payments to employees, a former employee in the amount and in the manner established in accordance with the labor legislation.

With regard to bringing to subsidiary liability for failure to file a petition for recognition of its company insolvent, there is a presumption of a causal link between the omission of the manager in the form of failure to file a petition to declare its company bankrupt and harm caused to the property interests of creditors because of the impossibility to settle the increased debts.

The fundamental issue in considering the petition for subsidiary liability in case of failure to file a bankruptcy petition will be the determination of the time when the debtor’s manager should have found out about the company’s signs of insolvency or other grounds for filing a bankruptcy petition. Difficulties may arise with the determination of the time with respect to some grounds for filing a bankruptcy petition by the debtor. The court in this case will proceed from the principle of good faith, namely, when in a similar situation in the framework of the company’s regular business activities, a reasonable and conscientious manager should have found out about the signs of insolvency and insufficiency of property and submitted a relevant petition to the court.

For example:

In case No. А50-20613/2010 of 08.09.2014 the Supreme Court of the Russian Federation established that the manager is considered aware of the signs of insufficiency of property from the time of signing the financial statements. However, accounting statements alone cannot be indicative of the company’s impossibility to perform its monetary obligations to creditors without a documentary analysis of the contained records. As a rule, the amount of assets and the amount of the company’s liabilities correlate in determining the formal sign of insufficiency of property. At the same time, the formal negative value of assets, determined according to the financial statements, in the absence of other evidence of insolvency, does not indicate the company’s inability to fulfill its obligations, for example, as stated in the ruling of the AC of FED No. F03-6136/2014 of 27.01.2015.

Actions (omissions) of the controlling persons, which resulted in the company’s recognition as a bankrupt

Owners and business managers often use various instruments to minimize risks in anticipation of bankruptcy. Liquid assets in the form of real estate, commodities and materials, rights of claims are transferred to other controlled legal entities; important documents are seized from the company’s files; bookkeeping is distorted. For a long time, various schemes for leaving problematic legal entities with debt obligations hanging on them have been popular among business owners: the companies change their legal address to a more remote one, a person who is unknown to anyone is appointed as a general director, and the interested persons themselves simply try to forget about these companies and to distance themselves from them as far as possible. But in the course of bankruptcy proceedings, these schemes can be disclosed by the bankruptcy trustee with the assistance of creditors or other interested persons.

It should be known that in relation to the ground for bringing to subsidiary liability provided by Clause 4, Article 10 of the Federal Law “On Bankruptcy”, there is a presumption of guilt of controlling persons in the following circumstances:

– Harm has been caused to property rights of creditors as a result of actions by this person or for the benefit of the person or the approval by this person of one or several transactions of the debtor, including transactions that have the signs of voidability in accordance with the Federal Law “On Bankruptcy”.

– Accounting and reporting documents at the time of the decision on the introduction of monitoring or decision to declare the debtor as a bankrupt are missing or do not contain information about the objects provided by the Russian legislation, or this information is distorted, resulting in significantly hampered procedures used in case of bankruptcy, including the formation and implementation of the bankruptcy estate.

– Claims of third-priority creditors for the principal amount of debt incurred as a result of the offenses for which there is a valid decision to bring the debtor or its officers, who are or were its sole executive body, to the criminal or administrative responsibility or liability for tax offenses, including the requirements for the payment of debt, revealed as a result of proceedings on such violations, exceed 50% of the total amount of the claims of third-priority creditors for the principal amount of debt included in the register of creditors’ claims as of the closing date of the register of creditors’ claims.

There is extensive court practice with respect to the first two grounds that allows saying how facts are established that presume the guilt of controlling persons at the submission of a petition for subsidiary liability. A prerequisite is the existence of a causal link between the use of its rights and (or) opportunities with respect to a controlled economic entity and a set of legally significant actions carried out by a controlled entity, the result of which is its insolvency (bankruptcy).

1. The liability provided for by Art. 10 of the Federal Law “On Bankruptcy” for non-transfer/lack of documentation is aimed primarily at the implementation of the opportunity to form a bankruptcy estate, in particular, by filing lawsuits to recover debts from third parties, by returning property from illegal possession and challenging the debtor’s¹ transactions. Therefore, the very fact of the manager’s evasion from transferring accounting documents to the arbitration manager is an independent condition for bringing to subsidiary liability. In order to bring the manager to liability, under these circumstances it is not necessary to prove that the absence of accounting documents entailed the company’s bankruptcy, because the very fact of their absence entails difficulties in the formation of the bankruptcy estate. However, arbitration courts in deciding on bringing of controlling persons to subsidiary liability proceed from the guilt and general provisions of the civil law, namely Art. 1064 of the Civil Code of the Russian Federation, which establishes that the person who caused harm is exempt from compensation for harm, if it proves that the harm was caused not through its fault, and the burden of proving the absence of guilt would fall on the controlling persons. For example, in case A05-1511/2011, the court of cassation instance left unchanged the ruling of the appellate court on the refusal to bring the manager to subsidiary liability without change and indicated that the manager had performed its duties for less than a month and in so little time could neither restore nor draw up the missing debtor’s documentation.
2. Causing harm to the property rights of creditors as a result of the commission or approval by the controlling person of one or more of the debtor’s transactions often means the transaction or a set of several transactions aimed at the withdrawal of the debtor’s assets without providing it with an economically justified equivalent or free of charge. It is important to understand that if in the bankruptcy case the petition for challenging the transaction is satisfied on the grounds stipulated by the Federal Law “On Bankruptcy”, when a part of the property is returned or the property in full is not returned to the bankruptcy estate, the fact of the court order will have a prejudicial significance in proving within the framework of consideration of the petition for bringing to subsidiary liability. However, when the property in full is returned to the bankruptcy estate, if the transaction is recognized invalid, there will be no grounds for bringing to subsidiary liability.
3. In the summer of 2016, a new basis for bringing to subsidiary liability of the director or other manager of the debtor came into force. Now it is possible, if more than 50% of all claims arose as a result of an offense (including tax offenses), which was committed during the manager’s office. This provision applies to a person who was the sole executive body of the debtor at the time the debtor or its sole executive body committed the offense. According to the explanations given in paragraph 9 of Article 13 of Federal Law No. 222-FZ of 23.06.16, the provisions apply to claims for bringing persons controlling the debtor to subsidiary liability or claims for bringing persons controlling the debtor in the form of damages recovery submitted after September 1, 2016. This provision is relatively new and currently there is little practice on it, but so far, as expected, the main applicant under such grounds for prosecution is the authorized body (the Federal Tax Service), for the convenience of which this rule was adopted.

Procedure for determining the amount of subsidiary liability

In case of satisfaction of a claim to bring a controlling person to subsidiary liability in the presence of uncompleted settlements with creditors, the court suspends consideration of this claim until the end of the settlements with creditors after the establishment of all other relevant facts. The courts proceed from the provision that the size of subsidiary liability of the person controlling the debtor is equal to the aggregate amount of creditors’ claims included in the register of creditors’ claims, as well as claims of creditors filed after the closure of the register of creditors’ claims and claims of creditors on current payments that have not been paid due to insufficiency of the debtor’s property. Consequently, the size of subsidiary liability can be definitively determined only after the end of the formation of the bankruptcy estate and the completion of settlements with creditors.

Innovations in 2016-2017

Federal Law No. 488-FZ of December 28, 2016 “On Amending Certain Legislative Acts of the Russian Federation” provides for a number of innovations aimed at ensuring the rights and legal interests of creditors in cases of bankruptcy of legal entities. In particular, for the Federal Law “On Bankruptcy” there are amendments that improve the mechanism of bringing to subsidiary liability persons controlling the debtor, namely one of the main innovations in the Federal Law “On Bankruptcy” in 2017 will be the possibility of bringing to subsidiary liability persons controlling the debtor already after the completion of company’s liquidation procedures.

The bankruptcy trustee, bankruptcy creditors and the authorized body will have more opportunities to form a bankruptcy estate, and the risks of managers and owners in case of unlawful behavior will increase, since now people who are entitled to file a relevant petition have three years after the completion of the bankruptcy procedure, and in case of valid excuse this period can be restored.

In general, there is a strengthening of the position of the authorized body in bankruptcy procedures. If we sum up the innovations in the legislation, in 2016, a new basis for bringing to subsidiary liability for offenses (including tax offenses) emerged, the notion of a “controlling person” has been expanded and the term of the pre-bankrupt period has been increased from two to three years within the framework of which grounds for bringing to subsidiary liability are identified.

In addition, the authorized body also received the opportunity to be included in the register of creditors’ claims within 6 months after its closure, namely, if on the closing day the register of creditors’ claims is not passed or the judicial act or an act of another authorized state body that in accordance with the legislation of the Russian Federation is mandatory for the identification of arrears is not effective. These claims shall be deemed to be filed on time. The specified provision gives additional time to the tax authorities and will allow including the maximum amount of debt on obligatory payments already after the register of creditors’ claims is closed, for example, based on the results of a field tax audit or submission of specified declarations by the debtor.

Decree of the Presidium of the Supreme Arbitration Court of the Russian Federation No. 9127/12 dated 06.11.2012.