Russian Bankruptcy Laws
Russian insolvency matters are governed by Federal Law No. 127-FZ On Insolvency (Bankruptcy) (the “Russian Bankruptcy Law”), which has been amended repeatedly since its introduction on October 26, 2002. In late December 2008, further reforms were enacted, including provisions on bankruptcy administrators, payment priorities, secured creditors’ rights, foreclosure on security during bankruptcies, and settlement of taxes. The impact of the Russian Bankruptcy Law and its subsequent amendments has evolved over time; after a few years, it created concern among businesses operating in Russia that the laws would be politically misused because politicians had too much of a role in the process. The implementation and execution of the Russian Bankruptcy Law by the Russian government has drawn criticism; such criticism and concern has become acute and renewed in light of the Ukraine conflict.
Perhaps the most significant development in Russian insolvency law prior to the enactment in 2002 of the Russian Bankruptcy Law occurred with the 1998 legislation, which replaced the 1992 bankruptcy law. The 1992 law was itself a new legal regime instituted in the wake of the fall of the former Soviet Union.
The 1998 amendments were a keen source of interest for both the media and legal scholars because they were heralded as a fundamental reform of bankruptcy laws that had allowed debtors, prior to the amendments, to run up insurmountable debt, which left very little to distribute to creditors or important constituencies like the Russian government and workers. The prior laws were criticized as being too debtor friendly, allowing weaker companies to continue to finance their struggling operations by not paying creditors. Many Russian economic and insolvency experts argued that the bankruptcy laws facilitated heavy payment defaults that Russian debtors were being allowed to accumulate before they were declared bankrupt. The 1998 amendments’ hallmark, and the topic of much of the discussion, was one of hope for a new economic pragmatism towards bankruptcy law that would help modernize the Russian economy. At the time, a payment default rate in Russia existed that threatened the viability of the economy, and those in support of the reforms felt that the bankruptcy laws were too lenient on defaulting debtors.
In April 2009, further amendments were made that included provisions on vicarious, third-party liability in a bankruptcy; lower voluntary bankruptcy filing thresholds; rules regarding conflicts by business entities; and provisions regarding bankruptcy litigation tools such as avoidance actions used to bring assets back into a bankruptcy estate (preference actions or fraudulent conveyances, for example). On July 30, 2017, significant changes were made to the Russian Bankruptcy Law regarding vicarious liability of controlling persons. These and other successive amendments to the Russian Bankruptcy Law were designed to perfect practical application of its provisions and to prevent perceived abuse by shareholders. Because of the prevalence of personal guarantees in Russia, it is also important to note that in 2015, the Russian insolvency laws introduced a personal bankruptcy act.
Russian “Rule of Law”
Though structural improvements have been progressively better through each amendment of the Russian Bankruptcy Law, there are strong opinions over whether or not the laws matter if such laws are not “honestly enforced.”
Legal scholars, journalists, and courts outside of Russia have been consistent in expressing doubts over the legitimacy of the actions of Russian bankruptcy trustees, also known as bankruptcy administrators. For example, the 1998 bankruptcy law amendments were supposed to create a way for creditors to enforce claims, but they have been criticized as instead being used as a new mechanism for insiders to siphon off funds from minority shareholders and creditors; there have been allegations that the fiscal malfeasance has been facilitated by bribes to judges and bankruptcy trustees.
President Boris Yeltsin’s announcement in late 1999 that he would step down as president at the end of 1999 and designate Vladimir Putin as his successor was a surprise to many. President Yeltsin’s regime was tied closely to the rise of oligarchs who had profited from the large-scale privatization of Soviet Union’s economy. Some hoped that this surprise successor would bring a new direction for economic policy focused on further modernization.
The Demise of Yukos
The fate of the Yukos corporation is cited as the definitive indication of how the Putin regime would handle the economy and was lamented as a failure to address the cronyism of the Yeltsin regime. The chairman/CEO of Yukos at the time, Mikhail Khodorkovsky, was a Russian oligarch who attempted to enter into a merger with a Western oil company. The prospective merger was favorably received by the markets with a $43 billion valuation, though the good news came shortly before Khodorkovsky was arrested by the Russian authorities.
The Russian government did not formally privatize Yukos; instead it used the tax laws to orchestrate a takeover that not only jailed Russian nationals, but also rendered foreign and domestic investment worthless through enforcement of the Russian tax code. In April 2001, the Russian government imposed a total assessment of $3.4 billion in taxes owed and sought court enforcement against Yukos, which resulted in an order freezing company assets and forbidding the company from alienating or encumbering its property. The government then engaged in a series of actions that crippled both the company’s finances and its ability to pay any outstanding taxes. A judge who ruled against the government and tried to lift the freeze order was removed from the case and then fired, while a judge who ruled for the government was promoted. The courts also allowed procedural deadlines to be instituted that did not allow for time or access to review documents or evidence. Yukos’s legal department, in turmoil due to the arrests of Yukos personnel, was given exceptionally short deadlines to respond to the government’s case and no effective opportunity to review the government’s evidence. The government also argued that due to the asset freeze, Yukos could not liquidate any assets to pay the fine.
It soon became evident that the true objective of the government was to render the company insolvent and begin taking its assets; this was not done directly, but instead by proxies. In July 2004 the government announced the sale of a Yukos affiliate, YNG, which owned the majority of the Yukos production operations, by selling off the YNG stock owned by Yukos. The government increased the tax liabilities up to $24 billion, and then the sale only yielded $9.35 billion, despite YNG’s stock being valued at between $15 and $20 billion. A state-owned oil company, Rosneft Oil Company, purchased YNG. Yukos filed for bankruptcy protection in 2006; the courts, Rosneft, and the tax authority rejected its restructuring plan, and it liquidated in 2007, with Rosneft taking most of the assets. Promnefstroy, a former Rosneft subsidiary, was given the rights to Yukos’s Dutch subsidiary Yukos Finance B.V.
In March 2022, Russia’s ruling party, United Russia, announced a draft law that provides for the involuntary bankruptcy sale of assets left behind by departing companies from “unfriendly countries.” The proposed law would have placed entities that were 25% or more owned by foreigners from “unfriendly states” into bankruptcy unless they divested their holdings to a Russian entity. While the Russian government placed this draft legislation and similar, more direct, measures aside at that time, a new “Yukos” strategy has emerged out of the battling sanctions and countersanctions that have been implemented because of the Ukraine conflict, and recent countersanctions have involved seizures of foreign companies, which have been justified by the Kremlin as retaliation for seizure of Russian funds.
Russian Countersanctions, Indirect Expropriation
The Russian government has imposed significant “countersanctions” against “unfriendly countries” and controversial third-party sanctions against companies complying with the Western sanctions regimes against Russia and Belarus. This product of the Ukraine conflict was an anticipated, but no less disruptive, byproduct of the U.S., U.K., and E.U. sanctions regimes. The Russian countersanctions have complicated and stymied global efforts by corporations to comply with all applicable laws in the markets in which they operate and has exacerbated the exodus of companies from Russia. The hallmark of these government efforts by the Kremlin and the Russian legislature is a revitalization of the tactic of expropriation—especially indirect expropriation—which harkens back to familiar tactics utilized by the Soviet Union, but adapted to modern global economic and political norms.
Expropriation, the seizure of property of another country’s nationals by a sovereign, is a recognized right of sovereign states (“States”) under certain conditions. For expropriation to be lawful (i.e., where the State does not incur international liability), the taking must be for a State obligation, cannot discriminate against foreigners, must respect due process, and must entail prompt and adequate compensation. If expropriation is legal, compensation may limited “to the value of the company at the time of dispossession, plus interest to the date of payment.” Unlawful expropriation can allow for further damages, including lost profits.
Direct expropriation is a legal transfer of title or the physical seizure of property that benefits the State—or a State-selected third party—accomplished through formal law, decree, or physical act. Large-scale nationalizations are direct expropriation and are rare. Indirect expropriation is the complete or partial deprivation of a property right without a formal transfer of title or seizure. There are many terms for the variants of indirect expropriation, including de facto, creeping, constructive, disguised, consequential, regulatory, or virtual expropriation. Creeping expropriation is worth further examination. Creeping expropriation “encapsulates the situation whereby a series of acts attributable to the State over a period of time culminate in the expropriatory taking of such property.” The State can utilize regulatory, legislative, and judicial processes to interfere with property rights over time to dilute foreign nationals’ rights without transferring title or taking control of the asset.
Modern expropriations typically result from legislative, executive, and administrative acts, which include new legislation; resolutions; decrees; and revocation, cancellation, or denial of government concessions, permits, licenses, or authorizations that are necessary for the operation of a business. Judicial intervention is more rare. Investors have challenged confiscatory tax policy; the prohibition of distribution of dividends; labor regulations or other interference in staffing and operations; judicial decisions; financial regulations; and licensing regimes as expropriation.
Russian Response to Ukraine Conflict
The Russian commission on legislative activities has drafted proposed legislation nationalizing property of foreign organizations leaving the Russian market. It was first announced that the issue would be reviewed by a government commission in March 2022, but the law has not yet been passed. The proposed law on external administration for the management of a company would apply to companies with (1) over 25% shareholding (directly or indirectly) “connected” to “unfriendly” States (including place of registration and place of primary economic activity); and (2) a book value of over one billion rubles (around USD 12 million as of early April 2022) and/or over 100 employees. If passed, this law could have retroactive effect from February 24, 2022.
The proposed legislation would be direct expropriation that would arguably require compensation under international law. Since the Yukos takeover was so successful and was accomplished without payment from the Russian treasury, legislation has typically been geared towards indirect expropriation, which is harder to prove than a direct expropriation and easier to defend against in later lawsuits over compensation.
In May 2021, Russian Prime Minister Mikhail Mishustin signed a decree accompanied by a list of “unfriendly states” that “have carried out unfriendly actions” against Russia, Russian nationals, or Russian entities, primarily by restricting diplomatic relations with Russia. The original designation only included the U.S. and the Czech Republic and was made in response to separate denunciations by the U.S. and the Czech Republic for interference by Russia within the borders of each respective country. The list has been expanded multiple times, and its original purpose has been expanded by the Russian government as a response to sanctions imposed against Russia for its invasion of Ukraine.
On March 5, 2022, the Russian government approved the most recent list of “unfriendly countries,” which included Albania, Andorra, Australia, Canada, members of the European Union, Iceland, Japan, Liechtenstein, Micronesia, Monaco, Montenegro, New Zealand, North Macedonia, Norway, Singapore, San Marino, South Korea, Switzerland, Taiwan (the Republic of China), Ukraine, the United Kingdom (including Jersey, Anguilla, British Virgin Islands, and Gibraltar), and the United States.
Russia also instituted countersanctions by presidential decree on March 3, 2022, including a ban on trade, financial transactions, and the honoring of any contract with any party that is a foreign national of an “unfriendly country,” which is the legal designation for any country that has joined in the sanctions against Russia. The Russian government also passed a resolution that all transactions and operations between Russian companies and nationals from “unfriendly countries” must be approved by the Government Commission on Monitoring Foreign Investment.
The Russian government has also imposed currency restrictions on Russian banks so that their clients cannot withdraw more than the equivalent of $10,000 in U.S. dollars. Otherwise, currency can only be withdrawn in rubles at a rate set by the central bank. Any money deposited since March 9, 2022 cannot be withdrawn. The Russian central bank originally stated these restrictions would remain in place until at least March 9, 2023. The restrictions were recently extended to September 30, 2023.
Foreign nationals from “unfriendly countries” are subject to a compulsory license of their patents for a 0% royalty. Owners of Russian patents will receive no compensation for infringement in Russia for as long as the countries remain on the “unfriendly country” list, which is populated with countries that have imposed sanctions on Russia and Russian nationals for Russia’s invasion of Ukraine, as described above. The same type of legislation was extended to trademark and copyright infringement. Hasbro Inc. subsidiary Entertainment One UK, which owns the animated children’s television character “Peppa Pig,” brought a trademark and copyright infringement claim against a Russian citizen in the Russian Arbitration Court for the Kirov Region in 2021. On March 3, 2022 (after sanctions were imposed), the court overturned an award it had given to Entertainment One UK and held that the Russian citizen could continue to use the trademarks without payment or permission. The court ruled that a plaintiff domiciled in an “unfriendly country” cannot claim IP infringement against Russian defendants.
The most serious restrictions have been in the energy sector, where the government measures have been directly tied to the status of the foreign national’s country on the “unfriendly country” list. For example, there was a ban in 2022 on foreign investment in the energy sector. The law banned foreign investors from unfriendly territories and states from restructuring or selling their interests in Russian strategic enterprises, banks, energy companies, and mining companies until December 31, 2022. In practice this means the government can control the terms under which an investor can restructure/sell its assets and effectively can appropriate the assets indirectly. This law has been applied several times, where foreign businesses were essentially forced to sell or lose their businesses in Russia. The government is able to set the rates centrally under this decree.
In March 2023, Russian countersanctions were expanded. Businesses from “unfriendly countries” are now required to make a voluntary contribution to the Russian state budget, and failure to pay will subject the business to a government-appointed receiver. Shortly after, in April 2023, President Putin authorized expropriation of foreign-owned assets in response to the seizure of Russian assets. The first victims of these policies were, not surprisingly, in the very lucrative energy sector.
In late April, the Kremlin seized the shares of Finland’s Fortum (FORTUM.HE) and Germany’s Uniper (UN01.DE), which operate energy plants in Russia, and placed the shares in the custody of temporary control of Rosimushchestvo, the federal government property agency. Rosneft seized operations and remains in control of the facilities. The Russian government justified the seizures as direct retaliation for seizures of its assets by unfriendly countries.
Consequences for “Unfriendly Countries”
On October 7, 2022, the Russian government moved forward through presidential decree to disenfranchise the owners of the Sakhalin-1 energy project, including the foreign nationals of several countries that the Russian government has designated as “unfriendly countries.” ExxonMobil, a significant owner, operator, and partner in the project, had had difficulty with the Russian authorities since late summer 2022 and initiated a prerequisite to arbitration by sending a “note of difference” to the Russian government after President Putin issued a decree in August 2022 that blocked a sale of its 30% stake in the Sakhalin-1 project. The sale would have effectuated the exit ExxonMobil announced in February 2022 after the invasion of the Ukraine. While not naming a buyer in its SEC quarterly filing, it was reported that Exxon would be selling its stake to existing partner ONGC Videsh of India, which wanted to increase its existing 20% stake. Significantly, India has not joined in Russian sanctions and increased its purchases of Russian oil by 33 times since the invasion of the Ukraine. In April 2022, ExxonMobil disclosed a $3.4 billion write-down on the Russia exit and signaled a third-quarter $600 million impairment charge for unidentified assets. ExxonMobil had valued its Russia holdings at more than $4 billion.
ExxonMobil has denounced the decrees as an expropriation, stating: “With two decrees, the Russian government has unilaterally terminated our interests in Sakhalin-1, and the project has been transferred to a Russian operator.”
Through the October decree, President Putin seized ExxonMobil shares in the oil production joint venture and transferred them to a government-controlled company it established, managed by Rosneft subsidiary Sakhalinmorneftegaz-shelf. Foreign partners will have one month after the new company is created to ask the Russian government for shares in the new entity pursuant to the decree. In addition to ExxonMobil and ONGC Videsh, a foreign-owned entity affiliated with Japan’s SODECO also holds a stake in the project. The decree gives the Russian government authority to decide whether these foreign owners can retain stakes in the project.
President Putin used a similar strategy in a July 2022 decree to seize full control of Sakhalin-2, another gas and oil project in the Russian Far East, with Shell and Japanese companies Mitsui & Co and Mitsubishi as partners. On July 1, 2022, it was reported that Shell had lost its 27.5% stake in the Sakhalin-2 project after the Russian government transferred the project to a new holding company. Japan’s Mitsui & Co and Mitsubishi agreed to take shares in the new holding company, retaining their minority stakes in Sakhalin-2.
Multinational corporations have largely been driven out of Russia and suffered a similar fate as Russian citizens who were targeted by the Russian government in the recent past. The Russian government has used regulatory and tax regimes to soften companies, even jail the management, and then seize the assets through the bankruptcy system. The Ukraine conflict has created a sanctions war between the West and Russia where both sanctions regimes have placed corporations in the precarious position of having to navigate between them and risk penalties from lack of compliance within the borders of each regime by compliance in the other.
Another unwelcome product of the conflict and related sanctions regimes is the adaptation of these same takeover techniques to accelerate the exit of foreign companies from Russia and disguise expropriation by using regulatory and legal justifications to seize foreign company assets within Russia. So what recourse is there for foreign companies who have lost millions in their investment and assets in Russia during the Ukraine conflict?
Lessons from the Yukos Bankruptcy
The litigation that followed the dissolution of Yukos provides a useful history regarding the legal issues, opportunities for recovery, and potential liability for those seeking to exercise their creditor’s rights against the Russian government. The Russian government did not stop with the dissolution of Yukos; it pursued employees and management of Yukos who left for fear of criminal prosecution. Extradition requests and subpoenas for records of third-party corporations were denied because the applicable domestic courts outside of Russia had serious reservations about the Russian judicial process, including the criminal and tax proceedings in Russia. The Russian bankruptcy administrator sold Yukos Finance B.V. in the Netherlands and Yukos CIS in Armenia to Rosneft and Promneftstroy, a former Rosneft subsidiary. In assigning the Dutch assets to a locally controlled Dutch trust, the Dutch court held that it was primarily motivated to put the assets in trust by the lack of integrity in the Russian proceedings, which failed almost every possible standard for a proper adjudication of the issues.
Bankruptcy courts in the United States are likely to have limited success in untangling insolvency matters in Russia, especially those that are a result of countersanctions. Chapter 15 was added to the U.S. Bankruptcy Code to facilitate cross-border cooperation between U.S. and foreign courts where assets in multijurisdictional disputes are a common challenge. Typical of many treaties, there is a public policy exception in chapter 15, which allows a U.S. bankruptcy court to refuse to cooperate in a cross-border dispute, if cooperation is “manifestly contrary to the public policy of the United States.” The entirety of the current U.S. sanctions regime is based upon the isolation of Russia from the global financial system, and no U.S. bankruptcy court would likely facilitate any payment that would proceed through Russian financial institutions. Section 1503 also prohibits any action that conflicts with a treaty or “other agreement” with other countries. The U.S. currently is acting in cooperation with its allies and partners to impose both export controls and a wide range of sanctions.
Prior to the 2022 invasion of Ukraine, and outside of the current U.S. and E.U. sanctions, a U.S. bankruptcy court granted recognition of a Russian insolvency proceeding as a foreign main proceeding in the In re Vneshprombank case. The U.S. Bankruptcy Court of the Southern District of New York allowed a Russian trustee to take discovery in order to trace and recover a failed Russian bank’s allegedly stolen funds, which were taken by two New York LLCs and deposited within the U.S. Two prior Chapter 15 cases were less successful: one where the Russian foreign representative dropped the matter, and another where provisional relief was granted but the case was dismissed before recognition.
In 2004, embattled Yukos tried to file a U.S. bankruptcy to stop Russian tax authorities from auctioning off its Siberian oil-pumping subsidiary Yuganskneftegaz to collect on the $27.5 billion back tax bill that had been assessed by the Russian government. The U.S. Bankruptcy Court for the Southern District of Texas initially granted a temporary restraining order and preliminary injunction to stop the sale, holding that the evidence presented “support[ed] a finding that it is substantially likely that the assessments and manner of enforcement regarding Plaintiff’s taxes were not conducted in accordance with Russian law.”
The court later granted a motion to dismiss the case brought by Deutsche Bank AG, rejecting arguments made regarding lack of jurisdiction, forum non conveniens, comity, and the act of state doctrine. The court instead dismissed the case based upon a review of 11 U.S.C § 1112(b), holding that a variety of factors warranted dismissal. It held that it was impractical to expect that the Russian government would cooperate with the case (and the court deemed such cooperation essential to the bankruptcy), that funds that were transferred to the U.S. were done so immediately before filing and to create jurisdiction in the U.S., and there were multiple other forums in which Yukos had filed seeking relief which the court felt were as capable as, if not more capable than, the U.S. Bankruptcy Court in determining matters under foreign law.
Multilateral and Bilateral Forums
The U.S. suspended bilateral engagement with the Russian government on most economic issues in response to Russia’s ongoing violations of Ukraine’s sovereignty and territorial integrity. Russia is a party to 60 bilateral investment treaties, including many with countries that are now listed as “unfriendly” under Russian sanctions law. There have been several arbitral awards against Russia related to the annexation of Crimea in 2014 that have had to be enforced against Russian assets outside of Russia. The various measures taken by the Russian government against “unfriendly countries” are in violation of these bilateral investment treaties (and many multilateral treaties). Investment treaties incorporate the basic principles of legal expropriation, which require the taking to have a public purpose, be nondiscriminatory towards foreign nationals, and be subject to due process. Investment treaties also regularly prohibit restrictions on transfers of funds.
Under the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (“New York Convention”), an award against Russia, which is a party to the treaty, can be enforced in the 169 jurisdictions that are also parties to the treaty. There are over 300 billion USD of Russian assets from Russia’s central bank that have been frozen by the U.S. and its allies, though it will take further authority from Congress to attach the assets that have been seized or frozen.
Russia is also a party to the World Trade Organization (WTO), and its measures against the intellectual property of nationals of “unfriendly countries” also could violate the extensive multilateral protections for intellectual property under that umbrella. However, Article XXI of the General Agreement on Tariffs and Trade (GATT) is a “national security exception,” which allows WTO members to breach their WTO obligations for purposes of national security. Article XXI of the GATT was invoked by Russia in a WTO panel dispute between itself and Ukraine over trade restrictive measures taken by Russia, and the Article XXI claim was upheld by a WTO panel on April 5, 2019.
Domestic courts have been largely unsuccessful in suits against the Russian government for lack of jurisdiction. International tribunals also have limited jurisdictional reach. Although Russia was not a party to or had not ratified certain signed treaties, claims have been brought under European Convention of Human Rights in the Strasbourg, though that court has limited remedies available to it.
Between the bilateral tribunals and the Strasbourg Court, litigants against Russia in the Yukos matter fared better under arbitrators. The Russian Chamber of Commerce’s International Commercial Court awarded $425 million to the Dutch trust pursuant to an arbitration provision in the loan documents based on a loan default to which Roseneft became a successor when it took over Yukos assets.
A Spanish arbitrator, pursuant to a bilateral investment treaty, found that unlike the Strasbourg Court, it did not have to analyze whether or not Russia violated its own laws or international norms; instead it had to determine whether nor not Russia engaged in expropriation and acted inconsistently within the expected and normal exercise of regulatory powers to enforce a tax regime. The arbitrator was particularly critical of both the Russian government and the Strasbourg decision under an expropriation analysis. The panel found that Russia had engaged in expropriation, which required compensation.
The accumulating volume and complexity of U.S. sanctions create serious risks for U.S. businesses with respect to both their own vulnerability to sanctions violations and concerns over retaliation from governments involved in the conflict. Proper redress at a later stage for losses incurred due to direct or indirect expropriation will depend on preservation of evidence and strategic planning in anticipation of which forums will be used to recover value from the consequences of the Ukraine conflict.
The pattern that has emerged from Russian countersanctions of using indirect expropriation though taxation, bankruptcy, intellectual property, currency restrictions, and investment controls should be carefully monitored and examined in formulating a strategic approach to the pursuit of recoveries. Equally important is whether assets seized as part of the Western sanctions regime will actually be available to satisfy the losses of these companies once they have found an appropriate forum willing to take jurisdiction over a commercial dispute stemming from a sanctions-induced loss.
The Russian approach to the Western sanctions regime is a direct extension of its recent history of using taxation and regulatory powers to attack real and perceived enemies within its borders, weakening them and then using the bankruptcy laws to take their assets. The countersanction regime justifies the adaptation of this use of government power against foreign companies, who have invested time, technology, and funds in Russia, by conveniently equating them and aligning them with their home countries, and then completely divesting their assets in the process under the color of law. This tactic, disguised as a legitimate exercise of government power, particularly within its borders, was questioned by some, and was criticized early on. The most recent manifestation of this policy, it appears, has no one fooled.