Russian Federation: Recent Developments of Russian Law

Last Updated: 13 August 2010
Article by Oleg Shvander

Despite this being a holiday season, the Russian Duma and Russian Government have not been idle. This Newsletter covers a number of very interesting topics which all have significant practical consequences for market players in Russia.

Igor Orlov writes about agreements between participants/shareholders of Russian companies under Russian law. Such agreements were made possible only last year and there is not much court practice to use as guidance. We have drafted several such agreements for our clients in the Moscow office and like to think that we have found the right formula.

Dmitry Milyutin talks about some very important changes in Russian law that currently exist in draft form only but may be promulgated into law in the near future. The changes mainly concern enhancing the liability for company management (i.e., directors) for acting (failing to act) recklessly or in bad faith. Rather peculiarly, the burden of proof that a director acted in good faith / did not act recklessly is on the director himself. We do hope this last provision will not find its way into law.

Tamara Benidze covers widely expected draft legislation on fighting insider trading and market manipulation. This legislation, if adopted, may have far reaching consequences given that it stipulates criminal penalties for its breach, leading to imprisonment.

Violetta Molchanova writes about the new resolution adopted by the Russian Government in July which clarifies instances when agreements between insurers working in the same market are allowed. This is a significant improvement which will, hopefully, clarify the rules for insurers.

New regulation permits agreements between insurance companies that are active in the same market

The Government of the Russian Federation issued Resolution No. 504 dated 5 July 2010, which specified the circumstances in which insurers operating in the same market are allowed to enter into agreements with each other for conducting joint insurance or reinsurance operations.

It will be recalled that Russian competition law prohibits any agreements between undertakings which may cause the restriction of competition. However in respect of the insurance market the legislators introduced some exceptions to that rule.

In particular, such Agreements between insurers can be deemed permissible where all of the below conditions are met at the same time:

Firstly, the object of the Agreement must be the performance of joint insurance or reinsurance activities in respect of one or more specified types of insurance or insured risks in the market.

Secondly, the Agreement shall provide for an opportunity for a party to withdraw from the agreement on a voluntary basis (by notifying other parties to the agreement in writing) and a relevant procedure for withdrawing.

Additionally, parties to the Agreement must bear joint and several liability for paying insurance claims or indemnity amounts under coinsurance or reinsurance agreements.

Another mandatory condition which an Agreement between insurers must meet to be deemed permissible is that the insurers' aggregate insurance premium in respect of each type of insurance or risk insured in the course of their joint activities under the Agreement shall not exceed 20% of the relevant market (or 25% in case of reinsurance). The total amount of insurance or reinsurance premium paid in the relevant market, which is necessary for calculating the insurers' aggregate share of the insurance / reinsurance premium, can be found on the website of the Russian Service for Insurance Supervision.

An important condition for permissibility of such Agreements is that none of the parties to the Agreement should be banned from providing the type of insurance/reinsurance or insuring/reinsuring the same risk which is stipulated in the Agreement, jointly with other insurers or on different terms.

The Government resolved that these general exceptions will remain valid for 10 years from the date on which the Resolution becomes effective

New bill to impose stricter liability on corporate management

At the end of June 2010 the Government of the Russian Federation brought in a bill "On amending certain legislative acts of the Russian Federation with regard to bringing members of corporate management bodies to responsibility".

The Bill seeks to amend the Arbitration Procedure Code, the Labour Code and the laws "On Joint-Stock Companies", "On Limited Liability Companies", "On Securities Markets" and "On Protection of Investors' Rights and Lawful Interests in the Securities Markets".

The Bill imposes liability on members of corporate management bodies for losses caused by their unreasonable and/or bad faith acts or omissions made while exercising their rights and responsibilities as corporate officers or directors. In particular, the Bill provides that a member of a corporate management body shall be deemed culpable where he or she acted unreasonably and/or in bad faith while exercising their rights or responsibilities. Notably, the burden is on the corporate manager to prove that there was no unreasonable/ bad faith behaviour on his or her part. The Bill lists specific indicators which help determine whether a corporate manager acted unreasonably and/or in bad faith.

The Bill also lists the events which constitute grounds for bringing corporate managers to responsibility, and establishes the persons to whom corporate managers are liable. A corporate manager is liable to the company for losses caused by his or her culpable (i.e. unreasonable or bad faith) actions or omissions. Apart from that, a corporate manager is secondarily liable, together with the company, to the company's shareholders, holders of the other equity securities of the company and/or other persons to the extent provided by applicable law, for losses caused by his or her culpable (i.e. unreasonable or bad faith) actions or omissions.

In particular, the bill provides that a corporate manager bears secondary liability together with the company itself for any losses resulting from a breach of the rules governing the acquisition of equity securities of an open joint stock company, a failure to give shareholders pre-emptive rights to buy shares or equity securities convertible into shares, a violation of the procedure regulating the exercise of such pre-emptive rights, a breach of dividend distribution deadlines and/or procedures and other violations as set out in applicable laws.

Along with the test for unreasonable and bad faith behaviour, the bill contains a list of specific rights and obligations of members of corporate management bodies, which is instrumental in establishing the legal basis of liability of corporate managers.

Additionally the bill contains restrictions by specifying categories of individuals who are not allowed to hold corporate offices. In particular, those include individuals who received a current disqualification order as a form of administrative punishment; those who have a conviction for a premeditated crime; those who were adjudged incapacitated or disabled by a court of competent jurisdiction, and some others.

According to the government, these eligibility limitations for a position on the board of directors or another corporate governance body will help to screen out those who are unable to exercise, reasonably and in good faith, their rights and responsibilities imposed by the society and therefore the law will reduce the number of violations in current corporate governance practices.

Where the functions of a company's sole executive body (CEO) are preformed by a management company, the bill envisages a possibility to hold the CEO/acting CEO of such management company liable for losses caused to the company and/or its shareholders. In this case the CEO of the management company and the management company itself will be jointly and severally liable.

Last, but not least, the bill lays the legal foundation for liability insurance of corporate managers.

Due to an express provision in the Civil Code of the Russian Federation, civil liability for failure to perform or inadequate performance of a contract can be insured only to the extent that such insurance is expressly permitted by applicable law. Therefore the bill seeks to amend the laws "On Joint Stock Companies" and "On Limited Liability Companies" to introduce relevant provisions. At the same time the bill provides that the material terms of any such liability insurance contract are required to be presented to, and, on presentation by the Board, approved by the General Shareholders Meeting.

On the question of agreements between participants of a Russian Limited Liability Company

It was already a year ago (to be precise, on 1 July 2009) that Article 8(3) of the amended Law on Limited Liability Companies, No. 14-FZ dated 8 February 1988 (as amended) (the LLC Law) permitted founders/participants of a Russian limited liability company (LLC) to enter into agreements to regulate the exercise of their rights as LLC founders/participants. Under such an agreement LLC participants would undertake to exercise in a certain way and/or waive their rights as LLC participants. Similar agreements are widely used, for instance, in common law countries; however, their application in Russia had been rather limited due to a number of factors, including the uncertainty of their legal status and inconsistent approaches taken by Russian courts. Whether the situation has changed by now, and what aspects should be taken into account when dealing with such agreements, will be the focus of this article.

Limited and insufficient legal regulation

Many practicing lawyers note that provisions of Article 8(3) are not sufficient to establish a clear regulatory regime governing agreements between LLC participants, especially since these agreements are not part of an established practice. Indeed, the legislator does not establish the legal status or the contents of these agreements in any detail; there is only a brief indication that such agreements are possible and what their object is. In fact, many view this as a general confirmation of the fact that such agreements may exist. Meanwhile, in practice, all manner of questions and difficulties arise when such an agreement is prepared, which may relate to the form and the substance of, as well as the parties to such agreements, as well as their implications for third parties etc. Many of these questions remain open and would not be resolved by applying general rules of the civil law.

Naturally, case law is intended to help resolve questions and difficulties, however no relevant case law has evolved over the past year, too little time has passed yet. LLC participants who enter into such agreements today are breaking new ground.

Formation

The applicable legal requirement is that an agreement in point shall be made in writing, and, moreover, in the form of a single document signed by its parties. Accordingly such agreement can not be amended or terminated other than in writing, and, where the written form requirement is not satisfied, the parties will not be entitled in the event of a dispute to rely on parties' witness statements to prove existence of such an agreement (however this does not rule out documentary and other evidence). Notably, according the general rule, failure to comply with the written form requirement will render an agreement invalid to the extent that applicable laws or an agreement between the parties contains an express provision to that effect. It should be noted here that the LLC Law does not contain an express provision to that effect and absence of written form does not render the agreement invalid. Finally, the requirement of the LLC law is that such agreement must be made in the form of a single document between LLC shareholders, overrides relevant rules of the Russian Civil Code providing that a contract can be formed by an exchange of documents by post, telegraph, teletype, telephone, electronic or other means of communication that allow to identify the document as originating from a party to the contract.

Parties

In practice a question arises whether any persons other than the participants - for instance, the LLC itself, potential future participants, investors, indirect participants (i.e. participants or shareholders of the LLC participant) or others - can be parties to an agreement in question. The law does not give an answer to this question: on the one hand, only LLC founders/participants are mentioned in it, and on the other hand, the law does not expressly prohibit third parties or LLC itself from joining into the agreement. Some of the commentators recommend keeping such agreements strictly between participants of an LLC to avoid adverse legal implications; others view involvement of other parties as acceptable and even desirable, especially where involvement of potential future participants or LLC itself is concerned. An interesting question is whether this type of agreement is binding on the LLC (or the management bodies of the LLC) in respect of which it is made, regardless of whether or not the relevant LLC is a party to the agreement. Finally, a number of questions arises where the agreement is entered into by some, but not all LLC participants.

Object, Terms and Conditions, Liability

In accordance with Article 8(3) of the LLC Law the LLC participants may agree on the following:

  • the manner in which they vote at general participants meetings;
  • obligation to agree on the voting option with other participants;
  • sale of all or part of its participation interests at an agreed price and/or upon occurrence of a certain event, or refraining from the sale of all or part of its participation interests until occurrence of certain events; and
  • other concerted actions related to the management, establishment, operation, reorganisation or liquidation of the LLC.

Clearly, this is not a closed list, which on the one hand, means that LLC participants are free to agree on the manner in which they wish to perform other actions, but, on the other, in each particular case, leaves open the question of whether this or that agreement is allowed by law.

It seems that most problems arise when an attempt is made to determine how provisions of said agreements relate to the imperative rules contained in the Civil Code of the Russian Federation and the LLC Law: these are the problems the judiciary will have to resolve in the first place.

It is clear that this type of agreements can not override imperative rules of Russian law or provisions of the company's charter. In fact, before these agreements were permitted by law the main argument against them was based on an interpretation of such agreements as contracts intended to waive or restrict one's legal capacity, which is contrary to the general rules of the Russian civil law. Such had been the prevailing view taken by the courts. In the light of legislative developments many lawyers currently share an opinion that such agreements create an obligation to do and/or refrain from doing certain acts or things, and should not be seen as deprivation or restriction of rights. Thus the participants agreement merely creates an obligation between its parties, and does not compete with the rules of corporate law which are set out in legislative acts and the company charter. Accordingly, a decision taken by the participant which is in conflict with provisions of such agreement will be valid under corporate law, and where a party has breached the existing participants agreement, this will not constitute grounds for challenging validity of any decision or transaction made by the LLC or involving the relevant party to the agreement (however the breaching participant will be liable to the other parties to the agreement). Nevertheless, this approach is yet to be established in the judicial practice, and a number of related questions are still outstanding (including the question of limitations of party autonomy). It will be judged on a case-by-case basis, whether a particular condition of a participants agreement is valid, and whether a particular obligation is acceptable.

Finally, a number of unresolved issues relate to the liability of a participant for a breach of the participants agreement, in particular, whether damages and penalties are adequate remedies for a breach and, most importantly, whether specific performance of contractual obligations should be available as a remedy.

In Russia the practice of participants' rights agreements is yet to evolve, and, in my opinion, it may take a long time. In the meantime, it is not without reason that some participants choose to incorporate a foreign holding company to fully own a Russian LLC and enter into shareholding agreements within that holding company, under the law of a jurisdiction in which such questions have been resolved.

Bill on combating unlawful use of insider information and market manipulation

At the beginning of July 2010 the Bill "On Combating Unlawful Use of Insider Information and Market Manipulation" was adopted in the Russian Federation. This bill seeks to ensure that market-based pricing mechanisms are used in the financial and commercial markets as well as to increase investor confidence, improve protection of investors' interests, facilitate efficient development and international competitiveness of these markets, and to reveal and stop any market abuse on regulated markets that takes in the form of unlawful use of insider information and market manipulation.

The bill gives a definition of insider information which was missing from the applicable laws and introduces the set of rules governing the use of such information. The Federal Financial Markets Service (FFMS) proposes to understand insider information as precise and specific data that has not been disclosed, distributed or released, as well as data that comprises commercial, trade or other secret which is accessible to a limited number of persons (i.e. insiders), and, if disclosed, distributed or released, can have a significant effect on the prices of financial instruments or products. The existing statutory definitions of privileged information and persons possessing such privileged information do not deal with the essence of the insider problem and the statutory definition of the term 'insider information' is long overdue.

In addition, the bill determines the circle of insiders and sets a ban on using insider information when entering into transactions. It is understood that participants in the securities markets will maintain registers of their insiders and take steps to detect and prevent unlawful use of insider information. The bill equips FFMS with a range of new powers to detect and prevent unlawful acts related to the use of insider information, including the power to call for documents and information, to carry out inspections, get clarifications, issue instructions to remedy violations, and suspend or revoke licenses for professional activity in the securities markets. Where it is necessary to conduct investigative operations aimed at detecting offences, FFMS is provided with a mechanism that allows it to involve law enforcement agencies, inter alia, to conduct general inspections.

Market manipulation is seen to include a number of acts, in particular, the dissemination – whether via mass media (including electronic mass media), public data telecommunications networks (including the Internet) or by other means - of false data that is capable of influencing price, demand or supply of a financial instrument or product, or the volume of trading. This provision caused an outcry in the media, because, on the face of it, the bill provides for criminal prosecution against editors-in-chief and editorial staff of mass media found to disseminate false or misleading information. According to the amendments, mass media workers will bear no responsibility for disseminating false information if a specific source is quoted verbatim or the material is reprinted from another publication.

Criminal Code of the Russian Federation is amended to include Article 185.6 "Unlawful use of insider information" that provides for a punishment in the form of a fine ranging between RUR 300,000 and RUR 500,000, or, alternatively, equal to the amount earned over a period of 1 to 3 years, or imprisonment for a term of 2 to 4 years that may or may not be combined with a fine of up to RUR50,000 or a fine equal to the earnings of the convicted over a period of 3 months, and/or a ban on holding certain offices or carrying on certain activities for a term of up to 3 years.

According to the bill, where a bank breaches the law while working in the stock market, FFMS is authorized to revoke the bank's license for operating in the stock market, and thereafter the Bank of Russia will have to revoke the banking license from that bank. The law will enter into force 6 months following its official publication. However the rules relating to the criminal prosecution will not be applied until three years after the publication date. Revocation of banking licenses from banks as a consequence of breach of the insider information law will start in three years.

Even now after the bill was adopted, the market players still have serious differences as to some of its provisions. By way of example, the Bank of Russia is not satisfied with its new duty to disclose its insider information in accordance with the general procedure, as well as the power of FFMS to influence the revocation of banking licenses and monitor the Bank of Russia for compliance with the insider information and market manipulation law.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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