Recently the balance of interests in the real estate market in Russia has shifted significantly. The reason for that change is that the economic downturn caused a declining demand for commercial nonresidential premises and reduced the revenues of many market players. The low demand for office and trade premises entails reduction of rental rates. In terms of financial crisis lessees are trying to reduce their rental costs and compel lessors to decrease the rental rates due to the current market situation. In this respect the most important issue is what legal options and mechanisms are available to the parties to amend or terminate an effective lease contract.
Discussed below are some recent rulings in Russian courts regarding extending lease contracts and/or amending its terms.
CASE: Kalinka Stockmann v. Smolensky Passazh
Serious problems for a lessor or lessee may arise if an effective long-term lease contract does not provide any grounds to amend rental lease rates or unilaterally rescind the agreement. The is especially true when external circumstances in the real estate market have substantially changed and the other party is reluctant to review the terms of lease in order to reflect these changes.
The latest example of a controversy between lessor and lessee of commercial premises is the notorious case of ZAO "Kalinka Stockmann" against LLC "Smolensky Passazh" and ZAO "Mosstroyekonombank" that was finally resolved by the Presidium of the Higher Court of Arbitration of the RF (further referred to as "HCA") just a few weeks ago.
Further let us briefly examine the merits and legal issues of this dispute and comment on the principal findings in the arbitration award and court's decision.
The dispute between the lessee (Kalinka Stockmann) and the lessor (Smolensky Passazh) arose from the duty to extend the existing lease contract concluded in 1997 with respect to the premises in the Business and Trade Center "Smolensky Passazh" in Moscow to another 10 year term. The lease contract contained a clause that entitled the lessee to extend the contract (that expired in 2007) to another ten-year term upon notification to the lessor within 6 months prior to the date of expiration of the contract. The clause also stipulated that the terms and conditions of the lease contract had to remain unchanged for the next term of lease. In 2007 the lessee duly notified the lessor of its will to extend the contract. However, the lessor did not agree and demanded to free the premises occupied by the lessee. Objecting to the extension, Smolensky Passazh referred to the losses that would occur if the lease relationship continued on the previously stated conditions. According to the provisions of the contract, the rental rate was determined by the parties at the beginning of the relationship (i.e. ten years ago) and was calculated on the basis of the lessee's annual turnover. The lessee's turnover was in fact very low in recent years, so that the continuation of the lease relationship would be unfeasible and unfavorable for Smolensky Passazh.
The circumstances of this matter allow us to conclude that the lessor made an obvious error during contract negotiation and formation of the lease agreement. In an attempt to contract a prospective foreign lessee, the lessor signed a long-term lease agreement (indeed for the period of twenty years) without setting up a mechanism for periodical rate revision. As a result, the lessor found himself in a very difficult position after ten years.
The contract incorporated an arbitration clause providing that all disputes or claims arising out of or relating to the lease contract shall be submitted to the International Commercial Arbitration Court at the Chamber of Trade and Commerce of the Russian Federation (hereinafter referred to as "ICAC"). Kalinka Stockmann filed an action to the ICAC aiming to resolve the dispute concerning the extension of lease. The arbitration tribunal of the ICAC adjudicated the case and made an award on 29.04.2008, holding the following: (1) to recognize the plaintiff's right to extend the lease contract entered into with the defendant; (2) to order the defendant – Smolensky Passazh – to extend the term of the contract for another ten years by means of signing and registering an appropriate addendum to the contract. Thus, the award was rendered in favor of the lessee; the arbitral tribunal supported the claim and held it to be in compliance with the Russian legislation dismissing the arguments of Smolensky Passazh.
However, that was only an interim victory for Kalinka Stockmann. Smolensky Passazh brought a petition to the supervising state court namely Moscow Arbitration Court claiming to set aside the ICAC award (case № А40-28757/08-25-228). Subsequently this case was litigated in the cassation instance - Federal Arbitration Court of Moscow region (Russian abbreviation – "FAS MO"), and the final verdict was made by the Presidium of the Higher Court of Arbitration. All the state arbitration courts upheld the claim and ruled to set aside the arbitral award on the grounds of article 34 of the Federal Law "On international commercial arbitration."
In the given case Smolensky Passazh raised many arguments to invalidate the award in its petitions filed in the courts. Among the appellant's grounds were: violation of the procedural rules by the arbitrators while dealing with the case; appointing a biased arbitrator; refusal to dismiss an arbitrator; non-arbitrability of the subject matter and contradiction of the award to the public order of the RF. The courts treated and evaluated these grounds differently and therefore came to their conclusions in different ways. Some grounds were initially upheld by the lower courts but then overturned; other reasons were initially disregarded and then later admitted by the superior courts. This disparity represents additional evidence that the Russian judicial practice still remains unclear and inconsistent as to the application of the principles of arbitrability and recognition and enforcement of the international commercial arbitration awards in Russia.
Without going into to much detail concerning all of the peculiarities and controversies of the court rulings in this case, we will illustrate below the most significant findings of the courts that can potentially impact the future legal practice.
First of all, FAS MO affirmed the conclusion of the Moscow Arbitration Court that the subject matter of this dispute can not be submitted to the arbitration. The courts held that the dispute involved the issue of state registration of the rights to an immovable property (under s. 1 of the article 452 and article 651 of the Civil Code of the RF (the "CC RF") an agreement to extend a lease contract requires state registration), and, therefore, affected public interests and belonged to the exclusive jurisdiction of the Russian state courts1. However, the panel of judges of the HCA did not agree with this statement when revisiting the case. In the Ruling dated 03 March 2009 No 17481/08 they argued that the subject matter of the dispute was not public on its character or the persons involved, and, therefore, such a dispute could be validly submitted to and resolved by an international arbitration. The issue of state registration of lease rights lies outside the scope of the claim to extend the term of the lease contract. The state registration requirement did not convert this pure commercial relationship to a matter of public interest. Nevertheless, the Presidium of the HCA did not express an opinion on this issue in reviewing the decision, choosing rather to remain silent on this problem. In summary, the arbitrability issue in disputes involving state registration of rights to real estate is still uncertain in our judicial system. Although the negative approach of the state courts is still prevailing in Russia, there are some visible steps demonstrating a possible shift towards a more favorable attitude of recognizing the jurisdiction of international commercial arbitration courts in this type of dispute.
Secondly, we draw your attention to the final Ruling of the Presidium of the HCA on the case (No 17481/08, as of 19 May 2009). In its decision the court focused only on a single reason for setting aside the ICAC award; considering no other arguments that were examined by the courts of the lower instances. The Presidium recognized the right to extension provision stated in the body of the lease contract but said that the "procedure of formation" of such an extension to the lease contract had not been established by the parties. Further, the HCA referred to the common procedure of extending the lease by concluding a new lease contract for the next term pursuant to article 620 of the Civil Code of the Russian Federation.
Based on these statements, the court concluded that the scope of the arbitration clause did not cover the conclusion of a lease contract for the new term, because the parties did not envisaged that and restricted the effect of the arbitration clause only to the disputes arising out of or related to the initial lease contract expired on 30.04.2008. Thus, the HCA finally held that the ICAC had no competence to arbitrate this matter.
In our opinion, there is a factual and logical mistake in the reasoning of the Presidium of the HCA. It misinterpreted the main legal issue in the dispute resolved by the tribunal of arbitrators, namely the issue of the validity of the substantive right of the lessee to demand the extension of the lease contract. The right for extension and conditions of the extension were laid out in the main lease contract, so that the given controversy arose from the contract itself and was within the scope of arbitration clause. The plaintiff grounded its claim on the terms of the lease contract as opposed to article 621 of the CC RF that can only be applied in the absence of the relevant contractual provisions. The lack of detailed procedure in the contract for specific ways of documentation and signing the extension is a simply technical issue and can not be decisive.
Application of article 451 of the Civil Code of the RF to lease contracts
This year FAS MO has made some other notable decisions concerning disputes between lessors and lessees dealing with changing conditions of the lease agreement and introducing appropriate amendments to the contract. The most significant legal development from those cases was the application of provisions of article 451 of the Civil Code of the RF regulating the substantial change of circumstances to lease contracts by the arbitration courts.
In the case OAO "Kompomash" (plaintiff, lessor) vs. ZAO "Kompomash-TEK" (defendant, lessee) the Moscow Arbitration Court supported the claim of the lessor and ordered the introduction of amendments to the lease contract and an increase in the annual rental lease rate pursuant to article 451of the CC RF (case № А40-80315/06-64-569). FAS MO affirmed the ruling; the HCA, in turn, also upheld the decisions of Moscow courts. The courts reasoned that the external circumstances had substantially changed since the date of entering into the contract by the parties. In the Ruling of the HAC on this case the court stated: the market value of the lease for the non-residential premises had grown to the extent that if the plaintiff could have foreseen that, the contract would have been concluded on substantially different terms. The market value of the lease was determined on the basis of the expert opinion made by an appraiser appointed by the court.
In another similar case FAS MO also came to a decision that the merits of dispute met all necessary conditions prescribed in s. 2 of article 451 and awarded appropriate amendments to the lease contract (case № А40-44212/07-64-364). The court held that the significant growth of rental lease rates in the market constitutes substantial change of circumstances in the meaning of the article 451. FAS MO asserted that the growth resulted from a change in the economic situation of the country due to objective causes. "The parties to the lease agreement could not foresee this violent change in the market and the plaintiff was not in a position to control or influence these circumstances acting diligently and in good-faith", so the HCA.
Therefore, in summary the arbitration courts of higher instances in Russia have adopted a new approach in the judicial practice allowing parties to a lease agreement to seek application of article 451 in a judicial procedure in order to amend the initial terms of the contract, primarily the lease rate (in the case described above the rate was increased in favor of lessors). We believe that these judicial precedents can potentially become an effective method for reviewing the lease rates for the benefit of either a lessor or a lessee taking into account the current financial crisis and turbulence in the real estate market. This approach is especially remarkable in light of general trend in judicial practice where the courts are reluctant to apply article 451 of the CC RF to other types of civil law relations (particularly to loan contracts).
1 This approach corresponds to the position indicated in clause 27 of the Informational Letter of the Presidium of the Higher Court of Arbitration of the RF as of 22.December 2005, No 96.
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.