“How the majority shareholders can protect themselves in a situation of conflict of interests and why they should realize it in Russia?”
The article of the managing partner of legal group PARADIGMA was published in the May issue of SPEAR’S RUSSIA.
Kliment Rusakomskiy and Nina Malkova – tell how the Russian majority shareholders can protect themselves in a situation of conflict of interests and why they should use legal mechanisms available in the country.
Kliment Rusakomskiy - Managing Partner of the Law Group “PARADIGMA”
Nina Malkova – Lawyer of the Law Group “PARADIGMA”
CALL OF DUTY
The role of shareholders in the corporate management increases due to the concentrated structure of the Russian companies’ share capital. As a consequence a clash of interests between majority and minority shareholders becomes inevitable. Given this confrontation a company’s shareholder who in practice also manages its activities shall be aware of a potential risk of recovery of damages in case a corporate conflict arises.
Until now such concepts as “piercing corporate veil” and “holding liable shadow directors of a company” were associated only with the law of England and Wales, the High Court of Justice of England and Wales and the London Court of International Arbitration. These concepts have not been associated with the Russian law, the Moscow Arbitration Court or any other court of Russian Federation. However, since September 2017 risk of recovery of damages from shareholder or another third party caused to a company has become a reality for the Russian business.
Until 2014 cases of recovery of damages from controlling persons were considered only when these persons were held subsidiary liable for the company’s debts while the company is in bankruptcy process. Additionally section 2 of the legal act “On insolvency (bankruptcy)” stated that the controlling person is a person that had or has a right to give directions mandatory for the debtor or has other rights to determine actions of the debtor during the period of two years – until arbitration court accepts a bankruptcy petition. If the company is not yet declared insolvent remedies are not available under the national jurisdiction.
However, when the section 53.1 of the Civil Code сame into force it became practically possible to recover damages from company’s controlling persons and until the official declaration of financial insolvency of the company. The section 53.1 states that persons who are authorised to act on behalf of the legal entity, members of collective bodies and those who have an actual possibility to determine actions of a legal entity are obliged to compensate losses caused to that entity following a legal action of the entity itself and its shareholders.
Nowadays the concept “controlling persons” includes beneficiaries, “shadow directors” and other persons who de jure cannot be related to the company but in fact they identify its activity. Liability for damages may arise out of failure to perform obligations, namely to act reasonably and in good faith in favour of the company represented (that is analogous to the Anglo-American legal institutions of duty of care and duty if loyalty). Interpretation of the concepts “good faith” and “reasonableness” has been given by the Supreme Arbitration Court of the Russian Federation that represents the established approach of Western European countries.
WE SHALL CONSIDER SEVERAL EXAMPLES OF JUDICAL PRACTICE REFLECTING THE ESSENTIAL APPROACH OF THE LAW-ENFORCEMENT AUTHORITIES ON THE QUESTION OF LIABILITY OF CONTROLLING PERSONS
“Unfairness of director actions (or failure to act) can be proved in particular when the director knew or should have known the fact that his actions (or failure to act) at the time of their completion were not in the interests of the corporate entity. An example is if the director concluded an agreement with a company incompetent of making agreements (a fly-by-night company, etc.)” (section 5 subsection 2 of the Supreme Arbitration Court’s Resolution of the Russian Federation № 62).
More than 192 mln rubles have been recovered from the former General Director of a joint-stock company – as a compensation for the damages caused to the company. The court held that during several years money were transferred from the joint-stock company’s bank account to four other organisations for the payment of contract work they had performed. Moreover the General Director claimed that there was no need to hire new contracting organisations as all the work can be performed by means of the company. A practical interest of this case is that during the process the Investigation Department of the Russian Ministry of Internal Affairs (MIA) presented information on the case of investigation of the criminal activity of Mr N. connected to the embezzlement of public funds of the Russian Federation under the guise of illegal refund of value added tax. The court has been informed that the four organisations which are considered in this case are fictitious, the companies are under control of Mr N. and are registered in the name of false directors. The monetary funds have been transferred to the corporate bank accounts by the real legal entities (including the company’s shareholders) in the guise of sham transactions.
The court regarded the fact that the former General Director had not made any efforts to find out any information about the companies to which the money has been transferred for several years as a deliberate failure to perform duties imposed on the General Director and as a dishonest activity.
“Negative consequences of the case do not constitute bad faith and (or) unreasonableness of actions (failure to act) of director by themselves as a possibility of negative consequences happening goes along with risky nature of entrepreneurial activity. An aim of judicial control is to provide protection for legal entities and their shareholders but not to check economic efficiency of decisions taken by directors. Therefore a director cannot be held liable for damages caused to an organisation in cases when his actions (failure to act) were not beyond limits of a general business risk” (paragraph 2 section 1 of the Supreme Arbitration Court’s Resolution of the Russian Federation № 62).
Another case is concerned with a former General Director of a company whose area of practice is investigation and maintaining security. The former Director concluded a number of lease contracts with a company that belonged to his son. The company claimed damages from the former employee on behalf of the new General Director since it did not provide any decisions or approval of the related-party transactions. In addition these transactions did not present any economic interest: at the moment of the lease of five transport vehicles there was only one employee who in fact was that former General Director. Moreover the court held that during the lease period the company did not carry on any commercial activity.
However, the court took the side of the former General Director. The court held that the lease contracts in dispute were signed in order to satisfy the requirements of the licensed agencies of MIA of the Russian Federation in accordance with the law "On Private Detective and Security Activity in the Russian Federation". One of these requirements states that a company must have at least one car for each protection site. Therefore the court held that the proof of economic inexpedience and inconsistency was absent in the case.
The approach of arbitration courts of resolution corporate disputes related to recovery of damages from company’s controlling persons is becoming more meaningful. We also would like to highlight the advantages of the national court system when dealing with such legal disputes.
A PARTY IS ENTITLED TO OBTAIN IMMEDIATE ENFORCEMENT OF THE INTERIM RELIEF MEASURES IN RUSSIA IF A CORPORATE DISPUTE IS HEARD ON MERITS IN THE RUSSIAN ARBUTRATION COURT
A party is entitled to obtain immediate enforcement of the interim relief measures in Russia if a corporate dispute is heard on merits in the Russian Arbitration Court. For example, the party is entitled to obtain an immediate enforcement of injunction on holding shareholders meetings, seizure of corporate rights of the controlling person or corporate rights of the third parties, etc. Another advantage of hearing such cases within the national jurisdiction is their low legal costs incurred during the dispute resolution.
In addition it is quite difficult to enforce a court decision that has been issued in a foreign jurisdiction or at an International commercial arbitration trial on the territory of the Russian Federation. To enforce a court order issued in a foreign country a party to the dispute will need to go through special legal proceedings to recognize and enforce such order. If the court order in question contradicts the national public policy a national court will refuse to recognize such order. That means that the order will not be enforced in Russia. For example, formation of governing bodies of a Russian legal entity is regulated exclusively by corporate legislation of the Russian Federation. Therefore when questions of corporate management are regulated by foreign law and international arbitration clauses are fixed in the internal corporate documents business owners take a big risk (a good example is an experience of the shareholders of the company “Megafon”).
A legal mechanism available for the Russian business that allows to recover damages from company’s controlling persons following a legal action initiated by company’s shareholders or by company itself can effectively protect interests of a shareholder. In particular cases it can also be a useful tool for the third parties to perform hostile takeovers.
There was also a notorious conflict of “Ulmart” company’s shareholders when a minority shareholder of the online retailer company brought a legal claim to the London Court of International Arbitration against majority shareholders. The minority shareholder accused the majority shareholders of impairment of his corporate rights in relation to the company management and of bringing the company to an unfavorable financial condition. A few years ago filing this type of claims to the Russian Arbitration Court was not possible. However, today the Russian Arbitration Court can be regarded as an authoritative body that is capable to decide whether there is a real damage caused or a mere greenmail.
In the current situation we would recommend business beneficiaries and other controlling persons of company to fully comply with corporate procedures set out by the present legislation and companies’ internal documents while taking strategic decisions. This will allow to minimize the risks of liability arising for the controlling persons.