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New stage of the domestic corporate law development

As the events over the past few years have shown, in the Russian bankruptcy and corporate law there appeared an unknown category of persons named corporate beneficial owners. Every year the number of cases in which courts are forced to move away from a formal view on the participants in a legal entity as true owners of business is increasing. Here we are talking about cases where not only the beneficial owner recedes from the loans of the entity controlling it, but also where the beneficiary reveals himself/herself/itself in order to be able to protect his/her/its interests. Pavel Vitalievich Khlyustov, an attorney at law, candidate of judicial sciences, partner of Barshchevsky & Partners Bar Association, told us about the ways of establishing the practice in settling economic disputes with the participation of beneficial owners, and whether they can be released from responsibility by a complex system of offshore companies, and whether the Russian courts need a doctrine of “piercing the corporate veil», as well as further development of judicial practice in solving these issues.

Editor: Pavel Vitalievich, how would you describe the legal status of a corporate beneficial owner from the point of view of Russian law?

P.V.: Speaking about beneficiary owners, we should admit that today we are at a new spiral of domestic corporate law development. At the same time, it is necessary to understand that we are only at the beginning of the road, so now it is impossible to talk about the completion of the beneficial owner’s legal status formation. We can only talk about small fragments gradually converted into a picture. I have no doubt that this process will develop further.

Let us recall that even 10-15 years ago many people would come to the view that the category of the beneficiary owner was foreign to the Russian private law. However, time has shown that this is an erroneous thesis. And this is primarily due to the fact that almost all of the medium and large-sized Russian businesses are built in such a way that their true owners are safely hidden behind the network of legal entities and nominal owners.

For the time being, when the Russian economy faced favorable conditions, such a model did not cause a threat to turnover. But the echoes of the global financial crisis of 2008 led to a sharp increase in overdue liabilities and, as a result, to the growth of bankruptcy cases. Thus, many lenders found themselves confronted with many millions, and often billions, of gaps in the balances of once reliable, as they thought, counterparties. They could bring participants and shareholders to subsidiary responsibility. But even the few who managed to do this eventually did not get anything, because these «participants and shareholders» were ordinary nominals and dummies. Beneficial owners managed to evade responsibility.

To resolve the current situation, there were two ways either to move away from formalism in judicial practice and finally to recognize that, in addition to participants and shareholders, it is necessary to allocate another category of beneficial owners, or leave the solution to this problem at the mercy of uncivilized ways of debts repayment.

Fortunately, the Supreme Arbitration Court of the Russian Federation that existed at that time selected the first way and gradually steered the judicial practice in the right direction. The Economic Board of the Supreme Court of the Russian Federation continues to move in this direction. The legal reform regarding bankruptcy and legal entities led to the situation in which an ultimate beneficiary could become a full-fledged subject of legal responsibility. In this situation, the legal status of the ultimate beneficiary has, apart from advantages, disadvantages. As a result, over the last decade, the legal status of the ultimate beneficiary has taken on a certain form. From the entity that could take off the cream and act as a puppeteer with impunity, the final beneficiary gradually turns into the entity that can be held legally responsible.

Editor: Now the number of criminal cases, the parties to which are beneficiaries of bankrupt enterprises is increasing. How effective is this way for repaying debts to defrauded lenders?

P.V.: There is no universal recipe. Obviously, lenders are trying to use any chance to get money back. Civil and legal and criminal law mechanisms are applied. And the main task of law enforcement bodies is to prevent criminal law mechanisms using as means of blackmail, and beneficiaries turning into scapegoats for mistakes made by the company’s management board. Investigative bodies should clearly understand that reasonable business risk is not equal to crime. In the meantime, the practice is that the bodies often exert unreasonable pressure on the owners of bankrupt businesses, and the latter, fearing to be imprisoned on fictitious grounds, prefer to repay the company’s debt at the expense of own funds.

Partly, it is for this reason that the number of cases related to the settlement by a third party being a beneficiary of claims filed by lenders in the bankruptcy proceedings increases. Although this is a rather painful phenomenon, one can find its positive consequences. The increase in cases of fulfillment of bankrupt’s liabilities by a third party is one of the reasons for further improvement in the legislation regulating this procedure. Let us take, for example, the bankruptcy case of My Bank. This was for the first time when the liabilities of the bank’s lenders had been fulfilled by a third party that paid more than 15 billion rubles. At that time I was involved in the legal analysis of Article 189.93 of the Federal law on Insolvency determining the procedure and consequences of settling liabilities by the lender at the expense of funds provided by a third party. It was found out that this article had a serious gap related to the fate of the bank, liabilities of which were settled, but which was denied a new license. The legal provisions had deficiencies, but it was of no interest to anyone, since there were no actual cases of such article application at that time. As a result, the case of My Bank served as the basis for making changes in Article 189.93 of the Federal law on Insolvency to resolve this issue.

In general, it is necessary to understand that criminal law mechanisms should be used only in exceptional cases, when there is sufficient evidence of crime elements in the beneficiary’s acts. Errors in making strategic business management decisions that led to bankruptcy cannot themselves serve as grounds for criminal prosecution. This does not mean defenselessness of lenders because they still have the opportunity to bring the beneficial owner to subsidiary liability.

Editor: Do not you think that active bringing of participants and beneficiaries of a legal entity to subsidiary responsibility can undermine the importance of the legal entity’s institution?

P.V.: We too often idealize some elements of legal frameworks turning them into sacred cows, thus forgetting about their intended purpose. We lack flexibility. The doctrine of separating the personality of a legal entity from the personality of its participant, which originates from the Roman law and which was actively developed by lawyers in the late nineteenth and early twentieth, is the fundamental basis for modern corporate law. Its logical continuation is the principle of separating the property of a legal entity from the property of its participants, which is referred to in Article 56 Civil Code of the Russian Federation.

However each rule has exceptions. Such a corporate shield represented by a legal entity, can only give advantages to participants while it is used to satisfy legitimate interests. When a legal entity becomes a tool for deception and fraud, the rule of law cannot be lenient towards this and continue to grant its frivolous members and beneficial owners the privilege of limited liability. We often forget about it either deliberately or by naivety. Therefore, it is entirely natural that when persons who knowingly led the company to a state when it is unable to pay off lenders are forced to share the burden of debts with it.

If we refer to the developed law and order, we will see that there is no state that would not allow for attraction of controlling entities guilty of bankruptcy of a legal entity. For example, everyone knows a famous English case Salomon v. Salomon & Co. of 1897, in which the principle of separating the property of the company from that of its participants was formulated. English courts sacredly honor it, but in some cases it is not applicable and does not allow unscrupulous participants to be released from liability.

For this reason, the possibility of bringing controlling entities to liability for their wrongful actions can in no way affect the value of the legal entity’s framework. On the contrary, the opposite situation, when lenders of a legal entity remain defenseless and may not protect their rights by lawful methods, does make it possible to raise the question related to further meaning, significance and devaluation of a legal entity as a legal framework.

Nevertheless, I believe that with subsidiary liability another problem associated with bankruptcy arises. In the judicial practice there is a troubling tendency to unreasonably bring controlling entities to subsidiary liability. Our legislation quite correctly states that bringing to subsidiary liability is possible only if controlling entities are guilty of the debtor’s bankruptcy. This rule is very important, since it does not allow for bringing controlling entities to liability for justified economic risks. However, in recent years, courts have not taken this aspect into consideration, and thus subsidiary liability is actually formed on the basis of risk, not guilt. This is especially true for bankruptcy cases of credit institutions. That phenomenon is all the more deplorable as it indicates a fundamental judicial error.

Editor: But what about the opposite situation, when lenders of the beneficiary owner levy execution upon the property of the legal entity for his/her/its personal debts? You represented one of the parties in the Supreme Court of the Russian Federation in the high-profile case of Alfa-Bank v. Senatorov, in which the bank disclosed a multi-stage offshore ownership structure and levied execution upon the property of the legal entity for personal debts of its beneficiary in the amount of more than USD 50,000,000. Today this case is cited in all textbooks on the corporate law as an example of using the doctrine of “piercing the corporate veil» in Russia. How do you feel about this approach of Russian courts?

P.V.: Understandably, I will not delve into this case. I do not think that this case should be treated as a real precedent. In my picture of the legal world, it is on par with the case of retrieving Bashneft shares from AFK Sistema, or case of bringing Sergei Pugachev to subsidiary liability for Mezhprombank obligations, etc. That is the case when the court decision is made, and all the courts know about it, but there are no those committed to such legal position. Why? Because most lawyers perceive this not as administered justice, but as a tool for pressure or redistribution of tidbits.

As to the problem of prosecuting beneficiaries hiding behind offshore businesses, my personal observations show that until now the majority of judges have been ready to study and reveal a complex offshore ownership structure only if the subjects of the dispute are serious state structures or large entrepreneurs. It turns out that the opportunity to get to the beneficiaries remains the privilege of a few. Lenders that do not have necessary financial resources, and are not able to hire highly qualified lawyers and to spend money on collecting evidence, are most often doomed to failure. This means that an established system of offshore businesses, trusts and funds is still an effective tool for avoiding the liability of actual business owners.

Is it worth attempting to apply the doctrine of “piercing the corporate veil» to the local environment? My answer is yes. Sooner or later we will still do this. Our civil turnover consists of too many unscrupulous counterparties, one-day firms and nominals. This is not normal. Judicial practice needs a tool that would allow for pursuing the quest towards the corporate cover and bring any entity to legal liability. Of course, we may just use Article 10 of the Civil Code of the Russian Federation for this purpose and wait for judges to create our Russian analogue in 10-20 years by the trial and error method. But, in my opinion, we do not have to reinvent the wheel, but carefully study the experience of foreign law and order, where a similar tool has been used for many decades.

Having studied pros and cons, we need to understand what will be useful for us, and what may do harm, and then implement by the efforts of the Supreme Court of the Russian Federation prospective approaches to judicial practice. In any case, this tool should be used very carefully and only when there are no other ways to protect the conscientious party, otherwise stability of the turnover would have to be forgotten then, because we will unreasonably ignore the independence of the legal entity.

At the same time, we should not forget that the doctrine of “piercing the corporate veil» is a multifaceted phenomenon that embodies various legal approaches. For example, some lawyers mention not only cases of bringing participants to liability for debts of the legal entity or legal entity for the participant’s debts, but also cases of «imminent imputation», that is the possibility of attributing certain knowledge, behavior and legal status to participants and legal entities. Today we have a sufficient number of court orders, which testify to the formation of legal positions peculiar to «imminent imputation».

For example, in our judicial practice we have used a legal position for a long time, allowing us not to recognize an entity as a bona fide acquirer with the affiliation or another interconnection between the claimant and defendant at the time of transactions on alienation of disputed property. Or let us look at the case of Skakovaya, 5, examined by the Presidium of the Supreme Arbitration Court of the Russian Federation. It formulated a position on possible extension of prejudicial force of a judicial order to an unscrupulous affiliated offshore company, although it did not participate in the previous proceedings. This means that some elements of the doctrine of «piercing the corporate veil» have already taken roots in the domestic legal system. I think that this process will only develop with each passing year.

Editor: Last year, the Supreme Court of the Russian Federation recognized the beneficial owner’s right to challenge decisions of the general meeting and transactions made by the legal entity under its control. How do you rate this legal position?

P.V.: A person possessing the status of a beneficial owner should act in good faith and reasonably, which implies both abstention from actions that may inflict harm upon the legal entity, and active actions in the interests of the controlled legal entity. Recognizing the importance of the beneficial owner in corporate legal relations and imposing potential legal liability upon it, it would be appropriate and fair to vest it with certain rights that correspond to the substance of emerging legal relations. These rights should primarily include the possibility to appeal against certain corporate orders and transactions made by the legal entity. In this regard, the position of the Supreme Court of the Russian Federation in the Aspect-Finance case should be appreciated. A different approach, in my opinion, would mean unjustified disregard for material and legal interests that the final beneficiary undoubtedly has.

At the same time, we should understand that the possibility of challenging corporate orders and transactions by the beneficial owner is exceptional. This is especially true in respect to challenging transactions, because unlike the challenging of decisions made by the general meeting, there is a higher probability of intrusion into the sphere of legal interests of bona fide counterparties of a controlled legal entity.

It is important to bear in mind that when constructing a legal model of own business, the beneficiary should have been aware of legal disadvantages and advantages that the final beneficiary has against the participant (shareholder) of the legal entity. By choosing this scheme, the entity knowingly admitted that in the event of a corporate conflict or abuses on the part of managers, a number of legal tools that can restore the status quo will not be available to it as an entity different from any participant (shareholder) of the company. The transfer of this risk from the beneficiary to bona fide participants of civil turnover would be a fundamental mistake. It is the beneficiary that bears the burden of negative consequences of a selected legal model of doing business, as well as the risk of mistakes in appointing proxies who manage the current activities of legal entities. If any element is misfired, the negative legal consequences of this circumstance should first of all be imputed to the beneficiary.

Editor: Will the legal status of the beneficial owner continue to develop in our law? Could you tell us what it will look like in your opinion in ten years?

P.V.: Making forecasts is fruitless. I think that in next few years the Supreme Court of the Russian Federation will examine several cases, in which it will formulate legal positions empowering the beneficial owner.

First of all, this will concern the development of the legal position on the right of the beneficiary to challenge decisions adopted by general meetings and transactions made by the legal entity. In future, the beneficial owner will be able to recover losses from the bodies of the legal entity under certain conditions.

At the same time, the rights of the beneficiary in bankruptcy cases will also be expanded. It is possible that in case of any corporate conflict, the ultimate beneficiary will be granted rights similar to those granted to a representative of the debtor’s participants, that is, in a certain situation, the beneficiary will actually be able to possess the rights of the entity participating in the bankruptcy case. These approaches from the court practice will be transferred to the legislation.

Editor: Pavel Vitalievich, thank you for your input.

Interviewed by Nadezhda Yashina, Victoria Eremchenko, Moscow