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RUSSIA: Bankruptcy court still a case of "Russian Roulette"

The Deal
November 15th, 2004

Earlier this month, the CEO of Russian oil giant OAO NK Yukos announced that an emergency shareholders meeting next month will consider a bankruptcy filing. Authorities have hit the country's largest oil producer with billions of dollars in tax claims. CEO Steven Theede told reporters recently that the company received a new bill for $10 billion, rendering Yukos insolvent. The Kremlin last year jailed Yukos founder and controlling shareholder Mikhail Khodorkovsky on charges of fraud and tax evasion. The government has made no secret of its desire to grab and sell off Yukos assets.

A bankruptcy filing, however, could complicate matters considerably. It would freeze all pending court action. The Russian government couldn't seize Yukos assets for back taxes. And those tax claims? Under current Russian law, the federal tax authorities are considered unsecured creditors, so those claims are subordinate to those of secured creditors. And it remains uncertain what kind of say tax authorities would have on a creditors' committee, which appoints a bankruptcy manager that's akin to a receiver or a trustee in the U.S.

The Yukos case is being closely watched, even though, by some estimates, nine out of 10 bankruptcies in Russia involve small companies. Yukos is an important test of the workings of the nation's bankruptcy regulations not only because of its size but "because it will be carried out in public," a Moscow-based lawyer says.

The Yukos situation comes at a time when the Russian government wants to show its own people and the world at large that commercial and legal safeguards are in place. The nation's often-squalid business reputation has been born of a down-and-dirty transition after the fall of communism to a market economy. And in three attempts in the past decade to forge a stable and fair bankruptcy code, Russia has yet to succeed, even though it acknowledges such laws are the backbone of a functional economic system. To be sure, a working bankruptcy code is seen as necessary for everything from increased investment to a lower cost of borrowed funds.

Russia is still struggling to come up with a bankruptcy regime that works. There are reports that a fourth round of legislation is in the drafting stage. In October the Economic Development and Trade Ministry proposed making fictitious, intentional bankruptcies a "grave crime," punishable by up to six years' imprisonment. Even many critics now acknowledge that the framework for commercial bankruptcy is nearly in place.

The great disconnect in Russia hasn't been the code itself, however, it's been the execution of it.

"The laws are quite sensible," says Garegin Tosunyan, president of the Association of Russian Banksas well as the head of the Centre of Financial and Banking Law at the Institute of State and Law of the Russian Academy of Sciences. "[But] there's no implementation."

Since the fall of the Soviet Union, bankruptcy in Russia has been misconceived, misused and abused. In the late 1990s, it became a powerful tool, not of creditor protection and debtor rehabilitation but of corporate theft and judicial corruption. A Moscow police official charged earlier this year that as much as half of the country's bankruptcies were fictitious.

Lawyers cite small improvements in the court system that occur much farther from the public glare. But again, it's more a matter of curbing abuse rather than completing a successful workout.

"Over the last five years, the situation has been improving somewhat," says Alexander Temkin, senior manager of PricewaterhouseCoopers in Russia. "The share of abuse has lessened."

And while there are signs of progress, cynics still abound. "Bankruptcy remains the preferred mechanism for redistributing property," wrote Mikhail Delyagin, the economic adviser to Russian Prime Minister Mikhail Kasyanov, in a scathing newspaper column in September. Delyagin called bankruptcy "a double-edged sword of economic terror."

A major problem in Russia is the lack of uniformity in how bankruptcies are handled. "If it's a purely business matter, with no politics or other influence involved, yes, it's getting better. But if there's some kind of other [thing] in the equation, unfortunately, it's not," says Vasilisa Strizh, a Moscow-based partner at LeBoeuf, Lamb, Greene & MacRae LLP. "Practice differs from region to region, court to court, business to business." Nor has there been a notable bankruptcy success story in Russia, which is something the Yukos situation could help remedy. While abuse has been curtailed, professionals are hard put to cite a single case where a major company is being successfully restructured within the court. Temkin, for one, has witnessed more out-of-court restructurings than before. He also sees a continued reliance on collateral and assets rather than on rehabilitation. Creditors prefer to seize assets and sell them, he says, rather than "working with shareholders and other stakeholders with an aim of restructuring the company and seeing it repay the debt in full."

Who can blame them? If creditors such as the Russian tax authority that are owed billions aren't assured of a seat at the bargaining table, then what odds do small creditors face?

One case now under way in the Russian court system may help change that. A construction company from the Urals region city of Perm two years ago went bankrupt, and an external manager was appointed. In March 2003, a Japanese trading company filed a $3 million claim on unpaid bills for machinery and spare parts. The manager refused to honor it. A lower court upheld that exclusion on the dubious grounds that the trading company's power of attorney didn't conform to the 1961 Hague Convention.

Last month, however, a Russian appeals court ruling rejected that interpretation and sent the case back to the arbitrage court, which is presided over by local judges. If the claim is allowed, the Japanese company becomes the largest creditor, with an ability to convene a creditors' meeting and appoint a new bankruptcy manager.

"There's no assurance, but I believe we have really good chances of success," says the Japanese company's attorney, Viatcheslav Khorov sky of the Moscow office of Lovells. (Khorovsky declines to name his client.)

He and other lawyers in Moscow believe that the further up the judicial ladder a case goes, the more likely judges will make a reasoned decision. "Eight hundred kilometers from Moscow, a judge is just not prepared to apply laws that are dramatically changing year by year, becoming much more sophisticated, much more complex," says Dmitri Nikiforov, managing partner in the Moscow office of Debevoise & Plimpton LLP. "Judges at the higher levels enjoy much better compensation, much better respect. They are more professional and less corruptible."

In the Russian judicial system, higher court judgments don't necessarily become precedent. But some lawyers believe that the lower court judges will adhere to appellate rulings just to protect themselves. "Although the lower courts are not bound by these decisions, they will follow them," Nikiforov says.

How the courts apply the laws becomes critical to a working system. "If you look at transition economies, the laws on the books don't matter at all if enforcement is poor," says Ekaterina Zhuravskaya, an economist at the Moscow-based Centre for Economic and Financial Research.

Russian legislators made an initial stab at bankruptcy-related regulations in late 1992, just months after the Soviet Union fell. The law simply didn't work. Companies could easily escape, no matter how debt-ridden and insolvent they were.

Loopholes abounded. According to the regulations, for example, a company's debts had to exceed the total book value of its assets before bankruptcy could be initiated. To avoid bankruptcy, all a manager had to do, according to a detailed economic study on bankruptcy co-authored by Zhuravskaya, was issue worthless debt to his company at a high face value, thus increasing the nominal asset value.

In 1995, bankruptcy proceedings were initiated against some 1,100 companies, according to Zhuravskaya's study. But liquidation was ordered in less than half of these. Outside managers were named in just 135 cases.

The country's 1998 financial crisis illustrated the dangers of poor supervision. Six of the top 10 banks went bankrupt. The entire country suffered. The ruble was devalued. Investment stopped. Money fled. "It was a nightmare," says Pavel Gourine, who heads corporate and investment banking for Austria's Raiffeisen Zentralbank Österreich AG in Russia.

But because the bankruptcy code masked commercial weaknesses, the 1998 defaults were largely bank-related. Highly indebted corporations didn't fall, at least not then.

Just weeks before the August 1998 financial crisis hit, legislators enacted a revised commercial bankruptcy regime. This time, the pendulum swung the other way.

Bankruptcy became ridiculously easy to initiate. According to Zhuravskaya's study, some 11,000 companies went bankrupt in 1999, 10 times the number in 1995. A creditor could file a bankruptcy petition against a company if owed a debt of $5,000 or more that was only three months overdue. (In Russia at the time, 90-day arrears were the rule, not the exception.)

The law gave wide authority to local judges in the arbitrage courts to appoint a company manager, who was licensed by the states within Russia, not by the federal government. These local judges decided whether the enterprise would be liquidated. A judge could overrule creditors.

The law of unintended consequences came roaring to life. Crooked managers, dishonest competitors and plain old-fashioned commercial scam artists scored easily. Thousands of companies went bankrupt, but few were actually restructured. Instead, bankruptcy became a favored takeover method.

By ceding authority to poorly paid, inexperienced, pliant and easily manipulated judges, the system was tailor-made for abuse. Corrupt regional governors controlled the local courts. These powerful figures often acted as puppeteers of bankrupt company managers, especially since many incumbent executives bribed their way into remaining in control and not restructuring their companies. They stopped paying their debts. Company assets simply disappeared.

Under the law, the federal government could do little to intervene. Federal tax authorities were given no rights and had no stake in making the system work. They weren't even recognized as creditors.

The whole system, in fact, held legitimate creditors at bay. Judges could exclude some debts and allow others. "Until you are registered, you can't do anything, literally anything," says Anna Proshina, a Moscow-based associate with law firm CMS Cameron McKenna.

She describes one American bank client that had a major claim against a bankrupt Russian bank. After more than six months, the bank's external manager, the Russian equivalent to a bankruptcy trustee, continued to refuse to honor the debt. The American bank finally gave up.

"Managers used all sorts of methods to decline claims," Proshina says. "The goal was not to let anyone get close to the assets."

Zhuravskaya describes how managers were required to send out notices to creditors. But since all that was required under the law was to confirm an envelope was sent, managers dispatched empty envelopes.

It wasn't just the company managers who gained, however. Outside commercial interests could buy up cheap corporate debt. They could then hijack the process, force otherwise healthy companies into bankruptcy and, by pressuring arbitrage judges, put their own agents into the companies as managers. These managers would run up debts, then sell assets in sweetheart deals to their bosses for little or no money.

In the late 1990s, this became a favored method of seizing everything from factories to apartment buildings in Russia. In a press conference early this year, a senior police investigator, Anton Golyshev, called fraudulent bankruptcy "a disease if not yet an epidemic."

The courts moved at a snail's pace. Government investigators weren't much faster. Only recently have authorities taken action on abuses perpetrated under the old law. Often it's a matter of too little, too late.

For example, a judge put Primorsky territory fishing company Dalmoreprodukt into bankruptcy in July 2002. Yet it took until earlier this year for police investigators to announce criminal actions against the former management. According to an Itar-Tass dispatch, police accused the management of "premeditated criminal bankruptcy." But it was too late — managers sold 100 Dalmoreprodukt ships in private deals, transferring almost $23 million offshore.

Foreign investors got caught up as well. One of Russia's highest-profile and complex bankruptcy cases involved oil production company Chernogorneft, a subsidiary of Sidanco, in whichBP Amoco had invested $571 million in 1997 for a 10% stake. In September 1998, an arbitrage judge declared Chernogorneft bankrupt. This followed the purchase by competitor Tyumen Oil Co. of some Chernogorneft credit notes, then a demand by Tyumen Oil that Chernogorneft pay up.

Without shareholder approval, the judge appointed an external manager who had worked for Tyumen Oil's parent. His actions were so blatantly prejudicial to the company and shareholders that his license was eventually terminated by federal authorities, although a judge allowed him to continue auctioning off assets.

Two things followed. Tyumen Oil began to buy up credits and pressure other shareholders for proxies. At the same time, the manager cut sales and diverted oil supplies from Sidanco to two Tyumen affiliates at prices, Chernogorneft shareholders alleged, that were far below those the market would bear.

According to NoreX Petroleum Ltd., a Canadian company that held a majority interest in a joint venture with Cherno gorneft, the bankrupt company had assets worth anywhere from $1 billion to $2 billion. But the external manager set a maximum bid for the assets of $200 million. The manager excluded Sidanco from the bidding process and ignored an offer from BP Amoco to pay off the entire indebtedness. Tyumen Oil won the auction with a bid of only $172 million.

Tyumen Oil, which is controlled by Russia's Alfa Group Consortium, eventually returned some of the assets of Chernogorneft to Sidanco, but only after BP Amoco and the U.S. Export-Import Bank, which had underwritten a loan to Sidanco, pressured it to do so. (BP plc is now a 50% owner of Sidanco.)

But NoreX claims many Chernogorneft shareholders weren't so lucky. They were never repaid, asserts NoreX, which alone is owed more than $500 million for its share in an oil production joint venture it had with Tyumen Oil called Yugraneft Corp. NoreX argues that Tyumen Oil now owns Yugraneft illegally.

In February 2002, NoreX filed a racketeering charge in a New York federal court against Tyumen Oil and various subsidiaries and officers. It was dismissed last year based on jurisdictional issues and is now under appeal.

"What's really sad is that this was done on a large scale by very clever people," says Phil Murray, NoreX's president. "But this kind of corruption filters down from the very big to the very small."

In theory, such abuse is far harder to engage in these days because there are specific provisions to counter debtor, creditor and external manager abuse. That's because two years ago, in October 2002, legislators enacted a new bankruptcy code that required a more detailed and defined process, leaving less room for abuses, one lawyer says. "The new law plugged some loopholes," the lawyer notes. "Unfortunately, not the entire lot."

For example, professionals say that while the most recent law cuts down on the ease of fictitious bankruptcies, it's still too early to tell whether the system can actually work to rehabilitate companies in need.

Still, debtors now have the right to participate in bankruptcy hearings from the beginning. This prevents surprise bankruptcies, where debtors suddenly discover they're in receivership after the papers have been signed.

Shareholders now can also participate in proceedings, although they still have no voting rights.

Creditors' committees, meanwhile, can now demand an external manager. And these managers must be more professional and less prone to corruption than they were before. Among their qualifications must be an economics degree, at least two years' managerial experience and membership in one of the self-regulated organizations formed to provide bankruptcy managers. Creditors choose the organization, which offers three candidates.

Both the debtor and the committee also have been given the right to object to a candidate. And while an arbitrage judge technically appoints the manager, "the manager, to a large extent, is controlled by creditors," CMS Cameron's Proshina says.

The current Russian bankruptcy code is actually modeled on European common law. A creditor owed as little as 100,000 rubles ($3,500) can petition the court for a "debt judgment." Judgments take from three to 12 months before a final hearing is held to determine whether the judgment order becomes final. If so, a court bailiff attempts to enforce the judgment against the debtor's bank accounts and other property. If a bailiff is unable to do so within 30 days, a creditor can apply to put the debtor into formal insolvency proceedings.

A debtor can also initiate voluntary insolvency proceedings. In that case, an arbitrage court judge must approve the application, then appoint a temporary manager. During this time, management continues to operate the company but can't sell assets, obtain loans or assign rights without the temporary manager's approval.

At this point, creditors meet to set up a committee. Credit size and security determine not only the pecking order for recovery but also who gets clout within the committee.

In fact, Russian law now recognizes subordinated loans, a shift from when the courts made no distinction between senior and subordinated debt. It also recognizes the claims of the Russian tax authorities.

As a result of the separation of claims, a creditors' meeting is "extremely important," Proshina says. It can decide whether to distribute debtor assets to creditors, depending on priority claims, or restructure them under court supervision via a "financial rehabilitation," which is allowed for a maximum of two years.

In addition, the committee can demand a new external manager. While managers are self-regulated, they do have to be licensed by the federal government. External managers are powerful figures. They can dismiss executives, close facilities, sell property and negotiate debt restructuring with creditors. External managers are appointed for a maximum of two years.

At any time during this process, the debtor may seek what is called an "amicable agreement" to reorganize (in the U.S., this likely would be a consensual plan). All secured creditors must approve the plan, as well as a majority of all creditors. The arbitrage court must also approve such a plan.

If that sounds very American, it probably is. After all, while patterned after English common law, the Russian bankruptcy code has borrowed a thing or two from the U.S.

Witness the Russians' rules against fraudulent preference. A manager can unwind payments to creditors made six months or less before filing (under U.S. law, it's 90 days).

Because of a new emphasis on continued operation and rehabilitation, the current regime is considered extremely debtor friendly. "One of the purposes of the law is to provide business communities with additional tools to rehabilitate and, if possible, return to normal business," Lovells' Khorovsky says.

That, at least, is the hope. Moscow-based professionals emphasize that the law may be 2 years old but the current bankruptcy regime remains in its infancy. They also caution that the realities of business in Russia are considerably messier than the neatness of the law.

Determining ownership, for example, can be an impossible task. Even the country's largest parent companies are held by Cypriot or British Virgin Island corporations, which are, in turn, held by Gibraltar nominees. "You try to go after the owners, and you find 27 offshore companies," says one American business executive with longtime experience in Russia. "How can you track that?"

The answer for lenders is caution, RZB's Gourine says. "Know your client, try to learn who the real owners of the companies are, what their track record is, what their business strategies are," he says.

Security is also key. "It's very rare to lend money on an unsecured basis," Gourine says. "The presence of collateral is not only a possible source of repayment but also a way that allows creditors to be on top of other creditors."

He and other bankers report an extremely low default rate. For JSB OrgresBank, which caters to technology companies, "there has been no single default of a corporate loan in the last five years," says its chairman, Igor Kogan.

But Gourine also warns that competition is heating up. The country's total commercial loan portfolio is now about $100 billion. That may not sound like much, but it's 2.5 times more than what it was in 2001. And he fears that some banks will become less risk-averse.

In an effort to mitigate this risk, a new law that should go into effect next year provides for independent credit bureaus. "The impact of that is revolutionary," Kogan says, with some hyperbole. "It will decrease significantly lending risks."

Other bankers caution against reading too much into the action. The law provides for a clean-slate approach, so any data commercial banks have on clients now won't be allowed to be collected.

The system "will take at least a couple years to be meaningful," says Alexandre Kolochenko, who heads RZB's Russian retail operations. "The devil is in the details."

That cautionary note extends to Russia's legal environment. "It has dramatically improved from the beginning of the '90s to the middle '90s to right now," Debevoise & Plimpton's Nikiforov says. "It's now a matter of implementation and strict enforcement of the laws."

As the past has shown, however, that's much easier said than done.

Copyright 2004 The Deal, L.L.C.





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