Piotr Przychodzki and Andrei Markine

Unlike a number of other post-Soviet pitfalls, the Russian legal system's allowance of corporate debt evasion received very little attention. Nevertheless, chronic financial evasion, legitimized by the mechanism of legal procedures, became one of the key factors contributing to the massive and all encompassing crisis of the Russian Federation (RF).

Currently, Russian legislation and legal practices arm unscrupulous contractors with sufficient methods to establish procedural conditions that logistically avert the possible process of judicial debt collection. In the first and second installments of the series, we looked at common methods of collusion between Russia's legal, financial and corporate sector in rampant debt evasion. This week, we wind up the hit list.

Pre-trial abuse of Non-cash payment rules

The inclusion of the obligation to use payment requirements - another form of payment document - in the contract is another means of debt evasion. It is a method for impeding the collection proceedings activated before the trial. According to the CAP, item 8, 108:

The judge returns the statement of claim if no proof of the serving [of a collection order] in the bank or other credit establishment for the debts of the defendant is submitted, when according to the law, another normative legal act or contract should be received through the bank or other credit establishment. [1]

With the inclusion of such an obligation in the contract, the preliminary serving of a collection order to the bank is obligatory. However, many Russian banks that are not the assignees of the Soviet State banks and cannot effectively comply with the specified payment documents. The given circumstance delays debt collection. When the contract includes this obligation, it allows the debtor to utilize methods that were applied in the post-trial proceedings.

Creation of "artificial" creditors

Another widespread scheme to impede debt collection is the creation of artificial creditors, who are actually debtor controlled. When the genuine collector demands payments, the debtor begins "paying" debts to the artificial creditors instead. Upon the initiation of the genuine executive procedure, the debtor has no remaining property to compensate the actual creditor. Litigating such collusion with the artificial creditors is theoretically possible. However, its practical realization is very difficult, because of the near impossibility of the search to attain the appropriate evidence of the mock transactions.

It is extremely difficult to impede the recognition of the collusion of the artificial creditors and void the uses a non-state arbitration between the debtor and artificial creditor. The decision of a non-state arbitration court makes the unmasking of the fraudulent bargains difficult. It is most difficult for the non-state arbitration court decisions to be discredited in state court and to expose by preustitia [2] the collusion involved in the court's allocation of property. According to Priest and Klein, the inclination to litigate thoroughly relies on the parties' perception of the possible consequence of the litigation.[3] Despite the Western sources used for their study, it is applicable in the Russian setting. In both the East and the West, the decision to take action generally relies on the comparison of the costs of out-of-court-settlement versus litigation.

Transfer of arbitration proceedings to a biased party

The early transfer of disputes to a biased non-state arbitration court is another way to evade the collection. It is legislatively permitted for the corporate debtor to rely on a defense based on the principle of freedom of contract. This liberty can extend to the freedom of a clause for the predetermined arbitration. Furthermore, creditors do not always set the contract rules. This imbalance is indirectly permitted by the current legislation of the Civil Code, section 428 the "Contract of Adhesion."[4]

Undermining the debt payment sequence

By virtue of a pledge, the creditor (pledgeholder) - with regard to an obligation secured by a pledge - shall have the right, in the event of the failure of the debtor to perform this obligation, to receive reimbursement from the value of the pledged property preferentially before other creditors of the person to whom this property (pledgor) belongs with exceptions established by the law.[5]

Besides creating the artificial creditors, the illicit debtor transfers - along with their pledge rights - all or a large part of the property in question to them. Therefore, the genuine creditors are limited even in obtaining a partial settlement. Once again, the theoretical possibility of proving the collusion of a pledge is trivial. In practice, it is difficult to validate, confirming the findings by Priest and Klein.

Judicial orders for artificial wages

One of the methods to impede the creditor's efforts at this stage of the executive procedure uses the artificial creation of a significant volume of debtor liabilities for the salary of the debtor's employees. Considering the millions of unpaid workers, many staging strikes and blockades throughout Russia, unpaid salaries are not particularly suspicious in and of themselves.

When applying this method, the debtor provides employees with documents about the unpaid salary. Their value exceeds the real wages severalfold. It allows for a request to the court to obtain judicial orders - that is, a court injunction - to receive wages through an accelerated procedure. Of course, the debtor has an arrangement with workers to return the undue sums to cover debtor liabilities. This action creates a volume of priority requirements, based on which the executive documents (judicial orders) are made and which equal or exceed debtor liabilities. Furthermore, they are approximately equal to the debtor's property value. Thus all the genuine creditor actions - through the executive procedure - become ineffectual, as all funds obtained for the disposal of compulsory execution bodies will be allocated between "creditors" based on priority of reimbursement.

Realization and encumbrance of debtor's property

An equally effective impediment to collection is the sale or transfer of property to a firm controlled by the debtor, which often consists of its subsidiaries. Alternatively, the return delivery of this property in rent or in storage to the debtor is also possible. Despite the obvious collusion of the specified bargain, authorities that execute decisions frequently refuse to detain the sold debtor property until an explicit court decision renders the bargain null and void. Obtaining such a ruling depends on a large amount of circumstantial evidence.[6] The difficulty of obtaining such a volume of evidence makes this evasion method not only practical but also highly effective.

Liquidation of the debtor-firm

The most basic method of impeding debt collection is the liquidation of the debtor institution while transferring all contracts to another organization that formally lacks ties with the debtor organization. Moreover, the transfer of the rights and duties occurs through new contracts made with the same contractors and excluding the creditor.

Conclusion

The aforementioned legislation and use of legal practices provides the debtors with a wide variety of evasion methods. This should not be surprising. Commercial transactions between private parties were only recently legalized - after almost 70 years of suppression and even criminalization of private trade and commerce. As a result, Russia suffers from a lack of legal institutions with a credible history of contract enforcement as well as from a lack of a business culture that could provide a general source for a reputation-based sanctioning system.[7]

Fortunately, after the enactment of the Federal Laws "On Judicial Pristavs" and "On the Executive Procedure"; the Decrees of Government #934 (12 August 1998), "On Sequence of Arrest on Securities," and #723 (7 July 1998), "On the Storage of Arrested Chattels"; and the Order of the Ministry of Justice #76 (3 July 1998), "On the Procedures of Levying Collection of Debts on Properties of Organizations," the possibilities for evasion were lessened.

Even more critically, the apparent foreign cash inflow is now over. The governments and private sectors of the West are simply not willing to lend on the scale that followed the 1991 break-up of the Soviet Union. Hence, the very propensity toward debt evasion will be curtailed by the reduced cash flow.

Nevertheless, it is overtly optimistic to assume that the enactment of the specified normative acts entirely removes all practices connected with debt evasion. Along with the remaining loopholes, some residual practices do persist. Correspondingly, various questions require further research. It remains of pivotal interest to investigate how the persisting loopholes can be amended through procedural and normative means. This is and will be of vital importance to Russia's re-entry into the global economy as a player and hopefully, in the future, as a player of substance.

Piotr Przychodzki and Andrei Markine

Read Part I and Part II of this series.

Footnotes

1. "The Return of the Statement of Claim." Arbitrajniy Processualniy Kodeks. As published in the Vedomosty Federalnogo Sobraniya. #15, 21.05.95, s.58. Translated by Andrei Markine.
2. The concept of preustia means the evidence that was ascertained (determined) - by the judge with a judicial decision - in the litigation between certain parties shall not be proved again in further trails between the same parties". It is called "prejudicialnoe znachenie (significance)" of the judicial decision. It is a legal theory term and not a legislation of expression that can be readily found in the statues. This term has a Latin origin praejudicium; prae meaning first and judicium standing for judgment. Both terms combined stand for the English meaning the previous judgment or damage. In English, the word "prejudice" has a negative meaning. Its Russian counterpart has a neutral meaning.
3. George L. Priest and Benjamin Klein, "The Selection of Disputes for Litigation"' 13 Journal of Legal Studies 9184, 1.
4. "Article 428. Contract of Adhesion." Civil Code of the Russian Federation [Adopted by the State Duma on 21 October 1994 and 22 December 1995, as amended 20 February and 12 August 1996]. Parts 1 and 2. Translated from Russian by W.E. Butler. (London: Simmonds & Hill Publishers Ltd. The Primrose Academy Ltd. 1997.), pp. 198-199.
5. "Article 334. Concept and Grounds for Arising of Pledge." Civil Code of the Russian Federation. Adopted by the State Duma on 21 October 1994 and 22 December 1995, as amended 20 February and 12 August 1996]. Parts 1 and 2. Translated from Russian by W.E. Butler. (London: Simmonds & Hill Publishers Ltd. The Primrose Academy Ltd. 1997.), pp. 160 - 161.
6. Tatiana Boyko. "Interview with Vladimir Yarkov, Ph.D. of Jurisprudence, Professor of the Ural State Law Academy." Hozaistvo i Pravo. #6, 1998., p.51.
7. Katharina Pistor. "Supply and Demand for Contract Enforcement in Russia: Courts, Arbitration and Private Enforcement." Review of Central and East European Law. July 96, No. 1. 55-87.