Secondary liability of owners and managers in bankruptcy proceedings
Dmitry Yakushev, Attorney at Law
Andrey Gorodissky & Partners
Over the recent years a trend toward tightening liability of debtor controlling parties has been clearly discernable. Businesses take hard this trend and therefore legal disputes over secondary liability of directors stand out as a special category of disputes in case law.
Official statistics provided by Fedresource (government register of legally significant data related to entities and entrepreneurs) show that fears of managers and business owners are well grounded. During 2020 the number of persons held secondarily liable increased by three times as compared with 2016. (3,191 and 923 persons, respectively). The number of sustained requests for imposing liability is growing too. In 2016 courts in Russia sustained 22% of such requests, while in 2020 the percentage increased to 39%. In my opinion, there two key reasons for this phenomenon.
Firstly, in 2017 the Bankruptcy Law was amended so that practically anyone can be held secondarily liable. One of most notable worrying examples is provided by the Smyslovskiye case (No. А40-131425/2016), well noted by bankruptcy lawyers. The court held liable the children of the debtor’s beneficiaries, in whose name ownership of some property had been registered in order to get immunity against its recovery in favor of creditors.
Secondly, the criteria for imposing liability on managers are broadening. Nowadays managers are often liable not only for their demonstrably unfair conduct, such as extending loans to known insolvent companies or transfer of assets to other legal entities shortly before commencement of bankruptcy proceedings. Attempts are also made to impose secondary liability on managers and beneficiaries for managerial and strategic failures and errors that have led to unprofitability of business.
On one hand, this occurs because some transactions or decisions of top managers lie in the border area where it is not easy to distinguish between entrepreneurial risks and unfair conduct. On the other hand, Creditors are usually dead set on receiving at least some compensation. They assume that if the company finds itself in bankruptcy proceedings, this happens through the fault of the persons controlling it, and they interpret all facts relating to the debtor’s transactions against such persons. This is why a request for subsidiary liability is formally submitted in almost all bankruptcy proceedings, even if there is no objective fault on the management side.
Business judgement rule
The business judgement rule is enshrined in Section 18 of the Resolution of the Plenum of the Russian Supreme Court, No. 53, of December 21, 2017. According to it, managers cannot be held liable for standard business risks that may be faced in the course of doing business. In practice, however, the question arises: how to determine that a business risk was reasonable and justified in each particular situation?
According to Section 18 of Resolution No. 53 of December 21, 2017, the court assessing a manager’s decision should follow the established case law on corporate disputes, first of all disputes over recovery of damages. With regard to this category of disputes, the case law has developed criteria for assessment of a manager’s conduct, which should also be used for assessment of a business decision. With regard to the business judgement rule, courts rely on two key documents: Resolution No. 62 of the Plenum of the Russian Supreme Court of July 30, 2013 and Resolution No. 25 of the Plenum of the Russian Supreme Court of June 23, 2015.
So, a distinguishing line between business risks and unfair conduct is drawn by courts at their own discretion. Meanwhile, a director’s business decision is assessed in a situation where it is obvious that it did not yield a favorable result. Furthermore, judges are not always capable of adequate assessment of a director’s decision as they do not have sufficient knowledge of management practices, specifics of business and industry. As the research in the relevant case law shows, when assessing a manager’s business decision, courts mostly rely upon the following criteria:
1. Good faith, i.e. conduct expected of any person doing business. A director who knowingly and obviously acted in bad faith (e.g., made unjustified payments to an affiliate shortly before bankruptcy proceedings) cannot claim that his actions did not go beyond a standard business risk. The business judgement rule is not applicable to him.
2. Due care, i.e. collection of necessary information on the transaction and the contracting party.
Typically, a manager lacks due care if he enters into a major transaction which may have a substantial effect on the company’s financial position, without having conducted a due diligence investigation of the contracting party. If the director has made no arrangements for securing the performance of an obligation (by suretyship, pledge, prepayment or otherwise), creditors may eventually claim that he acted unreasonably or had unlawful personal interest in such conduct. If the contracting party fails to perform its obligation under the transaction and this failure brings about bankruptcy of the company, a court will most likely hold that the director’s conduct went beyond a standard business risk.
3. Acting in best interest of the company when taking a decision. The goal of any action of the management is to ensure that the company will receive profit and to prevent any adverse consequences, including bankruptcy, for its business. In other words, the manager should get no personal profit from a decision he takes.
4. In secondary liability matters, an important factor is economic viability of manager’s actions, which is the key criterion for recognizing a standard business risk in bankruptcy proceedings. According to Section1, para. 2 of the above-mentioned Resolution No. 62 of the Plenum of the Supreme Court, a court is not required to verify economic viability of a manager’s decisions. This does not mean however that a court is prohibited from assessing manager’s decisions on merits during bankruptcy proceedings. Moreover, it is mentioned in Resolution No. 53 of the Plenum of the Supreme Court, that a court is required to look into the reasons for bankruptcy of a company and to determine whether there is a casual link between the manager’s actions and the bankruptcy.
This approach is reflected in the Ruling of the Russian Supreme Court of September 30, 2019, No. 305-ЭС19-10079, case No. А41-87043/2015: “legal proceedings over imposition of secondary liability on controlling persons due to the impossibility to meet creditors’ claims should in any event be accompanied by the investigation of the reasons for the debtor’s insolvency. The fact that such claims are sustained shows that the court recognized the defendant’s actions as the cause of bankruptcy, while excluding other (objective, market0related, etc.) scenarios of deterioration of the debtor’s financial position.”
In a situation where the company has elements of objective bankruptcy, its director should be guided not only by the interests of its creditors, but also the interests of its creditors. Unreasonable and ill-grounded economic decision may lead to ultimate downfall of the company into bankruptcy and default on its obligations. Known disadvantageous conditions of a transaction, which are obvious to any businessman, may serve as evidence of the director’s unfair conduct and his intent to cause harm to creditors.
How a director can prove his innocence
When assessing a business decision of a bankrupt company, court consider to what extent the management’s expectations for receiving profits from a transaction or for preventing adverse consequences for the company were realistic. Therefore, a manager should be able to explain consistently to the court that the company went bankrupt not through his fault, the debtor’s financial position was uncontrollable and his actions were objectively aimed at stabilizing and improving the company’s economic position.
The director can also point out that at the time of taking the relevant business decision the company’s economic position was stable and its business transactions were made on market terms. Such circumstances can be used to prove that the manager reasonably took risks in order to increase profits or prevent bankruptcy of the business.
In other words, the manager should exhaustively explain to the court that he sincerely intended to receive profits, bring benefit to the company and used all reasonable efforts to collect and analyze relevant information and mitigate risks, but still his decision was unsuccessful and did not yield the expected results. If the director facing the threatening secondary liability is able to build his legal position relying on the above-mentioned legal aspects, there is a high probability that the judgment will be pronounced in his favor.
