Russian Federation: The Russian Financial Crisis: How Can You Recover Your Assets?

This briefing outlines certain key points which creditors should be aware of when attempting to recover assets from banks and companies in Russia. Its contents may be summarised as set out below.

• Section 1 (Introduction);
• Section 2 (Key Issues Relating to Bankruptcy Procedure) outlines the general principles applicable to all legal entities (companies and banks) concerning debt recovery and bankruptcy procedures in Russia;
• Section 3 (Banks - A Special Case) deals specifically with issues relating to debt recovery and bankruptcy procedures in respect of banks;
• Section 4 (Pre-Bankruptcy Strategies in Relation to Banks) analyses the debt recovery options available to creditors before a bank is declared bankrupt;
• Section 5 (Winding up of a Bank) summarises the winding up procedure applicable to banks;
• Section 6 (Other Remedies) sets out the options available during the liquidation procedure to creditors;
• Section 7 (Initial Conclusions) provides some thoughts on the current situation;
• Section 8 (Further Information) sets out the Norton Rose contact details for additional information regarding debt recovery and bankruptcy in Russia.

Russia has for some years had reasonably well defined rules relating to the collection of debts and the bankrupting of companies. Bankruptcy legislation has been in place since 1993, but early in 1998, this legislation was superseded by a new bankruptcy law, Federal Law No. 6-FZ of 8 January 1998 "On Insolvency (Bankruptcy)", (the "Bankruptcy Law"). The Bankruptcy Law currently applies to all entities, including banks. However, it should be noted that in July 1998 the Russian Parliament and the Federation Council approved a new bankruptcy law specifically relating to banks; this law is still awaiting President Yeltsin's approval and signature (the "Draft Law"). Provisions regulating the revocation of a bank's licence in the case of, inter alia, insolvency are contained in Regulation No. 264 "on the Revocation of Licences for Banking Operations of Banks and Other Credit Institutions in the Russian Federation" (approved by the Central Bank of the Russian Federation Order No. 02-78 of 2 April 1996) ("Regulation no. 264"). Some of the more salient provisions of Regulation No. 264, which was issued prior to the Bankruptcy Law, are examined in Section 3 below.

Since the Bankruptcy Law came into force, its provisions have not been applied extensively. Although it is clear that there are a considerable number of entities in Russia which are technically insolvent, there has been great reluctance to apply the remedies contained in the Bankruptcy Law. This is largely due to the fact that many of these entities are survivors from the Soviet era and, from a commercial point of view, are not worth winding up.

However, the current financial crisis in Russia involves newly formed entities which are the direct product of the "market reform" period of the Yeltsin years. Chief amongst them are a large number of banks which appear to have valuable assets such as properties and correspondent accounts outside Russia. Moreover, there are reports that some banks may have transferred funds offshore to third parties through a variety of transactions which could potentially be challenged. It will therefore be interesting to see to what extent the Bankruptcy Law is actually used by creditors in the current circumstances. Even if only a few bankruptcy petitions are actually brought and granted, this will undoubtedly influence the actions of other creditors. In particular, the fact that the Bankruptcy Law provides that a bankruptcy petition cannot be considered by a bankruptcy court for so long as a bank has a banking licence is a matter of considerable significance for creditors.

A creditor's remedy: From a creditor's point of view, the principle behind the Bankruptcy Law is quite clear. If a company has failed to pay to a creditor a debt which is in excess of Rs.43,000 on the due date and such failure to pay continues for 3 months, the creditor may petition the Arbitration Court (the "Bankruptcy Court") to recognise such company as bankrupt. The Bankruptcy Court must accept such petition within three days of receipt ("Acceptance of Claim"). According to the Bankruptcy Law, the Bankruptcy Court has virtually no discretion to reject a claim which complies with the requirements and formalities set out in the Law. Whether the Bankruptcy Courts will actually follow the spirit and the letter of the Law is still uncertain.

Jurisdiction: Only the Bankruptcy Court has jurisdiction to hear bankruptcy petitions and bankruptcy cases in relation to, inter alia, companies and banks. In the case of a company or bank, the relevant Bankruptcy Court is the one which is situated in the area in which such company or bank is registered.

Petitioners: Only certain classes of people can bring a bankruptcy petition. These include the company or bank itself and (as stated above), any creditor who, inter alia, has a monetary amount owing to him in excess of Rs.43,000 and which has been outstanding for more than three months before the presentation of the bankruptcy petition.

General Director's duties: It should be noted that, if it becomes clear during the liquidation of a company that such company will be unable to satisfy creditors' claims in full, the General Director of the company (or the liquidator) must present a bankruptcy petition to the Bankruptcy Court.

Evidence of debt: To support a bankruptcy petition, the creditor must provide evidence to the Bankruptcy Court of his claim. Such evidence could include, for example, a Russian court order or a promissory note. The Bankruptcy Law envisages that, at this stage, review of the claim by the Bankruptcy Court is minimal.

Acceptance of Claim: Acceptance of Claim by the Bankruptcy Court does not mean that the company has been found insolvent. It is merely the first step in the process of determining whether the company is insolvent; this issue will be determined at the hearing of the bankruptcy case.

Consequences: Where the Bankruptcy Court accepts a petition for bankruptcy in respect of a company, there are six principal consequences which flow from this decision.

• The Bankruptcy Court appoints a supervisor to the company (see "Temporary Supervisor" below);
• Creditors cease to be entitled to claim through individual proceedings and may only claim through the bankruptcy process (see "Restriction on Claims" below).
• The process of convening the Creditors' Meeting and appointing the Creditors' Committee commences.
• The company's management is left in place but its powers to run the company are restricted.
• Creditors can apply to the Bankruptcy Court to make orders "freezing" or otherwise protecting the assets of the company.
• It marks the commencement of the bankruptcy process. This is important for determining the period during which "preferences" can be challenged. It may also be relevant to rights of "set off".

Temporary Supervisor: The Temporary Supervisor's responsibilities include: compiling a list of creditors of the company, notifying such creditors (see "Creditors' claims" below), protecting the assets of the company, ensuring that the company's management do not undertake certain transactions and calling the first Creditors' Meeting.

Creditors' claims: The Temporary Supervisor must notify creditors as to the insolvency of the company. Following this, a creditor has one month following receipt of such notification to present his claim to the company. Claims are classified as "accepted" or "rejected" claims. The company has seven days to notify the Bankruptcy Court that it rejects a claim, following which such claim will then be considered by the Bankruptcy Court. If the Bankruptcy Court dismisses the claim, the Bankruptcy Law is silent on whether the creditor can appeal. The process of proving claims is important for obtaining representation at, and voting at, the Creditors' Meeting as well as for receiving rights to share in any resultant net assets of the company.

Restriction on claims: One practical effect of the acceptance of a bankruptcy petition by the Bankruptcy Court is that a creditor cannot make a claim to the debtor to recover its debts on an individual basis. All creditors (including secured creditors) must prove their claims through the bankruptcy procedure. Enforcement of existing court orders, for example, attachment orders, are frozen.

Creditors' Meeting: The Creditors' Meeting should elect a Creditors' Committee and decide whether to put such company into external management (broadly the Russian equivalent of administration in the UK), or to wind up the company. Banks may not be put into external management (see section 3 below). Any such decision has then to be approved by the Bankruptcy Court (see "Bankruptcy hearing", below). All creditors have a vote pro rata to the amount of their "accepted claims".

Creditors' Committee: Members are voted onto the committee by the Creditors' Meeting through a process of cumulative voting.

General composition of creditors: At any time during the bankruptcy process, the creditors and the company may agree a general composition (settlement). Such composition must be approved by a majority of all votes cast at the Creditors' Meeting (and such majority must include all the secured creditors) and by the Bankruptcy Court. Such a composition can only be concluded if the creditors ranking first and second (see below) have been paid in full.

Bankruptcy hearing: Within three months of the date of the Acceptance of the Claim, the Bankruptcy Court must commence the bankruptcy hearing (although the hearing can be adjourned for a further two months). At the hearing, the Bankruptcy Court must decide whether the company is insolvent. If it decides that the company is solvent, the bankruptcy process ceases. If it decides that the company is insolvent, the Bankruptcy Court can decide what action should be taken, based upon the recommendations approved by the Creditors' Meeting. Such actions can include:

• approval of a composition with Creditors if one has been agreed; or
• approval of a proposal to put the company into external administration for a period of 12 months (which can be extended by six more months) in order to assess whether it can be saved (this does not apply to banks); or
• ordering that the company be wound up whereupon, a liquidator is appointed and management is removed.

Winding up: If the Bankruptcy Court orders a company to be wound up, the Bankruptcy Law states that this should be completed within 12 to 18 months. The Bankruptcy Law provides that all debts and other amounts owing by the company are accelerated and become due and payable. It further provides that the liquidator should "get in" and realise the assets of the company, bring claims to overturn illegal or preferential transactions, bring claims against other persons who may be liable for the company's debts and pay off the classes of creditors in the order prescribed by the Bankruptcy Law.

Creditors - order of claims: Under Russian law, creditors' claims rank in the following order:

1 Personal injury compensation ;

2 Salary and other employment-related payments;

3 Creditors whose claims are supported by a pledge or mortgage;

4 State Tax Inspectorate and other State funds, including the Pension Fund;

5 All other creditors.

Court expenses, including the salary of the court appointed Temporary Supervisor, are paid out of the company's assets before all creditor claims.

Lower-ranked creditors may be paid only after higher-ranked creditors have been paid in full. If the company has insufficient assets to pay in full all the creditors of a certain ranking, they will be paid on a pro rata basis.

Creditors' Rights: The relationship between the temporary supervisor, external administrator or liquidator on the one hand and the Creditors' Meeting and the Creditors' Committee on the other hand is not clearly spelt out. However, disputes between them can be adjudicated by the Bankruptcy Court. This area is of particular interest in relation to the following:

• acceptance of claims - some creditors may seek to object to certain other claims being "accepted" or challenge acceptance(s) retrospectively;
• the institution of proceedings to recover property or former property of the company;
• the institution of claims against third parties such as the former management;
• the institution of proceedings relating to "preferences" and the exercise of set-offs and liens.

Assets of the company: The basic principle is that all assets belonging to the company (including those that are pledged) must be pooled. Creditor claims are then met out of this pool of assets in accordance with the ranking priority set out above.

Secured creditors: Secured creditors are given preference by reason of the fact that they rank third in priority. The property over which security has been granted should form part of the overall pool of assets which is available to meet creditors' claims. A claim of a creditor which is secured can be paid out of this overall pool; it appears that he will not be prejudiced by the fact that the value of his secured claim exceeds the value of the security. It is likely that many issues will arise in this area, including the following: pledgees in possession are unlikely to give up possession voluntarily; the "pro rata" principle could operate unfairly against creditors with valuable security; and, secured creditors with secured assets outside Russia are likely to rely on local laws which favour them realising their security outside the Russian bankruptcy process.

Set-off: In some jurisdictions, such as the UK, the setting-off of claims between an insolvent company and its creditors is mandatory, subject to certain limits. In other jurisdictions, including some whose law is codified, such set-off is strictly limited. The Bankruptcy Law does not mention set-off. It is likely that Russian law tends towards restricting set-off, although currently some market practice appears to be based on an assumption that Russian law is not restrictive.

Licences: It should be noted that as a general principle under Russian law licences are not transferable. Many Russian banks and companies hold commercially significant licences, such as a licence to deal in precious metals and stones, or a mineral licence. Liquidation is often a ground for an authority to terminate a licence; this may mean that the relevant time for such termination is the making of a winding up order.

Although debt recovery and bankruptcy procedures in respect of banks and corporates are broadly similar, in the case of banks there are some important differences.

Legislation: As noted above, at the present time, the Bankruptcy Law is the primary piece of applicable legislation. However, Regulation 264 needs to be considered carefully, notwithstanding the fact that it was issued prior to, and is subordinate to, the Bankruptcy Law.

The Banking Licence: For so long as a Bank retains its banking licence, the Bankruptcy Court cannot even accept a bankruptcy petition against such bank. A creditor can only seek to recover its debt; it cannot successfully petition to wind up a bank.

Withdrawal of a Banking Licence: Only the Central Bank has the power to withdraw a banking licence. It may withdraw a licence for a number of reasons, including where a bank has not paid a creditor for one month after the due date and such claim is not less than currently Rs.85,000 (the "Insolvency Reason"). There is no general obligation on the part of the Central Bank to withdraw a banking licence. It is worth noting that the Draft Law includes a procedure whereby a unpaid creditor can request the Central Bank to withdraw the licence and, if the Central Bank declines to do so, the Central Bank will be liable to that creditor for certain losses incurred by the Creditor.

Consequences of withdrawal of a banking licence: If the Central Bank withdraws a banking licence a number of consequences ensue. These include the following:

• Regulation No. 264 contemplates that the winding up process will inevitably take place;
• In general terms, all banking operations are suspended if they involve any reduction of the bank's assets. Thus, the bank ceases to operate as a bank.The bank's operations with all correspondent banks are suspended and the relevant accounts frozen until the Temporary Supervisor is appointed. With regard to a foreign bank who undertakes correspondent operations with a bank whose licence has been withdrawn, the Central Bank will "suggest" to such foreign bank that it suspend operations with the Russian bank.
• The bank must attempt to "get in" its assets, such as loans and property which are secured by pledges or mortgages.
• At any time after withdrawal of the banking licence, any creditor may petition the Bankruptcy Court, if he is within the eligible class of persons under the Bankruptcy Law (see section 2), to recognise the bank as bankrupt.
• All foreign currency debts are converted into Roubles at the Central Bank's relevant rate of exchange applicable on the date of withdrawal of the banking licence.

No external administration: It appears that the options facing creditors of a bank are either to agree to a general composition or to wind up a bank. External administration (as contemplated by the Bankruptcy Law) is not an option as the bank has already lost its banking licence and is therefore prohibited from carrying out the activities specified in such licence. However, the Regulation appears to permit a bank, with the approval of the Central Bank, to "alienate" its assets prior to the appointment of the liquidator.

Composition with creditors: It should be noted that the Draft Law excludes the possibility of a bank concluding a general composition with creditors. The Bankruptcy Law does not specifically exclude this; however, the theoretical possibilities of a creditors' composition agreement being entered into after the bankruptcy process has commenced and the licence being restored is unlikely. It appears that whilst the author(s) of Regulation No. 264 also regarded this as unlikely, they did not completely rule out the possibilities that a bank could be recapitalised and the banking licence restored.

Depositors: Individual depositors (physical persons) rank as priority creditors, having either priority to all other creditors or ranking with those creditors which are ranked first. Other depositors (including corporate depositors) continue to rank as unsecured creditors.

Before a bankruptcy petition is accepted by the Bankruptcy Court the options open to a creditor may include the following:

• a creditor may be able to seek to recover his debt using the appropriate court and/or arbitration procedures;
• a creditor may be able to consider whether it might be possible to agree a set-off of his claims with the bank (but it should be remembered that such set off could be subsequently challenged);
• a creditor may be able to commence legal proceedings in overseas jurisdictions to seize the property of the bank, including correspondent accounts and shares in foreign companies and real estate;
• a creditor may be able to commence discussions with the bank regarding a restructuring agreement (a restructuring agreement would necessarily include other key creditors, and may enable the creditor to recover more than he would than if the bank were to lose its banking licence).

Status of a Restructuring Agreement: If certain creditors and the bank enter into a restructuring agreement, the following issues should be borne in mind:

• any restructuring agreement must take account of the mandatory requirements of the Central Bank, which all Russian banks are obliged to comply with;
• there are restrictions on the aggregate amount of capital of Russian banks which may be owned by foreign entities;
• if more than 20 per cent. of a Russian bank is to be acquired (or an existing shareholding in excess of 20 per cent. is to be increased) by one or more creditors in the context of a restructuring, such creditors will need to consider whether the consent of the Anti-Monopoly Committee is required as well as that of the Central Bank;
• in practice, any restructuring agreement is likely to involve the approval of the Central Bank for regulatory and commercial purposes. The Draft Law provides that the Central Bank has powers to take measures prior to the removal of the banking licence to improve the financial standing of the bank via inter alia, financing, reorganisation and temporary administration;
• it should be noted that Regulation No. 264 envisages that a restructuring agreement could be entered into during the period after the removal of the licence but before the Bankruptcy Court decides at the bankruptcy hearing to wind up the bank.

Although the Central Bank has the powers to impose a temporary administration upon a Russian bank which still has a banking licence, recent experience would appear to show that such arrangements are not particularly successful.

Following an Acceptance of Claim, a creditor will need to consider the following issues.

Proving the claim: A creditor should notify the bank, the temporary supervisor and the Bankruptcy Court of its claim within the requisite time limits.

Rejected claims: If a creditor's claim is rejected, the Bankruptcy Court must decide, in the context of the bankruptcy hearing, whether the rejection was correct. In practice, this appears to mean that a Russian court will take jurisdiction over a claim where the contract under which it arises is subject to a foreign law and includes a valid arbitration clause. However, there have been few if any examples of how a Russian Bankruptcy Court will deal with this issue. Nevertheless, one cannot ignore the fact that one Russian judge has held certain types of forward contracts to be invalid on the basis that such contracts were gaming contracts.

Options: As mentioned above, the possibility of the bank entering into a composition with creditors appears fairly remote although it is not ruled out by Regulation No. 264. By contrast, once the Draft Law is enacted, such a composition is prohibited. It is therefore probable that the only practicable option is that the bank should be wound up.

Winding up procedure: Once the Bankruptcy Court orders a bank to be wound up, the main consequences include the following:

• a liquidator is appointed;
• management is excluded from managing the bank;
• notice of the bankruptcy is released in the press;
• the liquidator should collect in the assets of the bank, including instituting claims with regard to debts owed by third parties;
• all amounts owing by the bank become due (acceleration);
• a moratorium is imposed on all proceedings against the bank.

The liquidator must report on a regular basis to the Creditors' Meeting and/or the Creditors' Committee. A liquidator can be removed by the Bankruptcy Court at the request of the Creditors' Meeting and/or the Creditors' Committee.

In the course of a liquidation of a bank or company, the liquidator and/or creditor will need to consider the extent to which actions can be taken (a) to recover property and former property of the entity; and (b) to make certain third parties liable for the entity's liabilities. Actions may be taken in the following areas.

Assets located abroad: Some Russian entities have assets outside Russia which may be seized, such as correspondent bank accounts and shares in subsidiaries. It is likely that "ancillary" bankruptcy proceedings will be brought in the particular jurisdiction(s) if the assets are significant enough to warrant such action.

Tracing of assets: The tracing and recovery of assets located outside Russia is likely to be an extremely complex issue. Although sophisticated procedures have been developed outside Russia, it remains to be seen whether there is the will to use such procedures both within and outside Russia.

Illegal or invalid transactions: The liquidator will need to consider whether a transaction undertaken by the entity can be challenged on the grounds that, inter alia, it did not comply with Russian law. Areas to be considered include the provisions in the Joint Stock Law of the Russian Federation relating to "Major Transactions" and "Interested Party Transactions". Other provisions in the Civil Code and the Law on Hard Currency Regulation and Control may also be relevant.

Preferences: Transactions undertaken by the entity at any time after the day falling six months before the date of Acceptance of Claim which prefer one creditor over another can be challenged.

Directors: It is possible that proceedings could be brought against the entity's former directors and executives, whether for breach of law, negligence or on other grounds.

Parent company: Russian law allows the veil of incorporation to be pierced where insolvency occurs as a result of the parent company giving instructions to the entity which the parent company knew would result in insolvency. In such case the parent company becomes liable for the liabilities of the subsidiary.

Readers of this briefing will draw their own conclusions from the foregoing and from their own experience. In conclusion, we offer some tentative thoughts.

• In theory, the Bankruptcy Law provides a powerful creditor's remedy. However, enforcement of this law and of creditors' rights depends upon the Russian court system. Subject to a number of exceptions, the Russian court system does not have a record as a strong and independent upholder of investors' or creditors' rights.
• Russian Banks are protected from the rigours of the Bankruptcy Law so long as they have a licence. The policy of the Central Bank as regards the removal of banking licences is therefore a major element in determining whether a Bank will be allowed to go to the wall or will be saved.
• The system appears to favour a Russian Bank and its major creditors entering into a restructuring arrangement while the Bank holds its banking licence. Any such restructuring arrangement could be placed in jeopardy if the Central Bank withdrew the banking licence. Again, the policy of the Central Bank is a key issue.
• The policy of the Central Bank with respect to the above areas does not appear to be well known or widely disseminated.
• If a restructuring agreement is made between a Russian bank and its creditors, there may be few opportunities for creditors to examine whether assets have been transferred out of banks in a non-transparent way or in breach of legislation.
• If a banking licence is removed upon the grounds that a Russian bank is insolvent, there appears to be little alternative to a winding up. However, there are conflicting signals in Russian legislation (including draft legislation) and one cannot assume that this outcome will always occur.
• A winding-up should in theory provide the creditors with an opportunity to investigate previous transactions of the Russian bank, which may be illegal or a "preference". It will be interesting to see (a) the eventual composition of a creditors' meeting; and (b) the extent to which a creditors' meeting is prepared to pursue investigation of these transactions; and (c) if they are, the attitude of a liquidator and of the Bankruptcy Court.

As a final reflection, it is worth remembering the reported comments in the press of the last President of the Central Bank. He stated that one of the reasons why a bill was introduced in the Duma to nationalise one well known Russian bank was that it was thought that only in this way would one ever succeed in arriving at a true picture of the affairs of that bank and its associated companies. Such a view may well lead creditors of banks to reluctantly agree to a restructuring rather than embarking upon a journey which may be endless, unproductive, expensive and ultimately, frustrating. If many creditors reluctantly take that decision, the only question then is for how long the financial community will remember the old proverb: "Once bitten, twice shy".

This briefing has been prepared by Norton Rose Moscow and is intended only as an outline of the main legal considerations. It does not try to cover every detail and should not be used as a substitute for professional advice. Norton Rose takes no responsibility for the contents of this document. If you have any inquiries regarding the content of this briefing or about debt recovery issues in Russia in general, please contact us.