How to Sell a Stake in Business
New procedures for disposal of interests in Limited Liability Company charter capital.
On July 1, 2009 the Federal law №312-FZ passed by the State Duma on December 24, 2008 and enacted by the President on December 30, 2008 (hereinafter – Law №312-FZ) comes in effect. The named law introduces arguably the most significant changes to legal regulation of relationships connected with limited liability companies activities which are the most popular type of legal entities in Russian since the Federal law «On Limited Liability Companies» has been passed in 1998 (hereinafter — Law on LLC).
Among the numerous issues affected by the new law the principal place is designated for the revolutionary change of rules regulating disposition of participation interests or portions thereof in charter capital of limited liability companies. The redrafted Art. 21 of the Law on LLC entirely concerned with this issue takes up more than one quarter of the total text of Law №312-FZ when the very same article from nine paragraphs has grown to eighteen.
Considering the novels with regard to disposition of participation interests in company charter capital several key points are to be highlighted. First, the preliminary conditions to disposition, for example, requirement of compliance with preemptive right of other LLC participants to purchase a participation interest or in some cases their consent on disposal or consent of the very LLC as well as the very possibility for disposition of participation interests can be eliminated by LLC charter. Second, the procedure for disposition, namely a cumulative action solely by accomplishment of which we can trustworthy assert that a participation interest has been transferred from its ancient holder to a new one and that the rights of the hereof are duly secured and without leaving a possibility to be challenged.
Finally, the resolution of problems in event of any deviation to normal procedure for disposition of participation interest occurs, particularly, with regard to good faith acquisition of participation interests or portions thereof in LLC charter capital. The new law gives a significant attention to all of these issues, however due to some style and space limits in the present article we will concentrate just on the second issue – disposition procedures properly on the assumption that all the necessary preliminary conditions (notice of offer to exercise a preemptive purchase right, etc) are duly effected.
Procedure for Disposition of Participation Interests before July 1, 2009
First of all, let's remind ourselves the procedure for disposition of participation interest (or portion thereof – in the present context the difference is of little significance, therefore we will omit to further reservations) in limited liability company charter capital within the framework of ancient procedure which is in effect until July 1, 2009.
The first step to undertake in order to dispose of participation interest is to execute a disposition agreement. It can be any property disposition agreement – Purchase-Sale Agreement as the most prevailing one, donation, exchange, etc. Art. 21.6 of the Law on LLC provides just one mandatory requirement to Participation Interest Assignment Agreement – it has to be written under pain of agreement invalidity. A company charter can require a notary certification of such agreement just as an admissible option. The national civil legislation takes the simple written form to mean execution of an agreement in one of the following three procedures: first, common and widely known procedure of execution of a single document expressive of the parties' consent; second, it can be a document executed in counterparts each one of which is expressive of one party's consent to execute the agreement (Art. 434.2 of the Civil Code of the Russian Federation); finally, the written form of the document deems observed even in case when there is just one written document expressive of one party's consent to execute the agreement, i.e. in fact an offer to execute agreement while the other party acts in performance of this offer in terms stipulated in the offer concerned, for example, pays the amount specified (Art. 434.3, Art. 438.3 of the civil Code of the Russian Federation). Thus, until July 1, 2009 the disposition of participation interest in company charter capital is executed in a document which could hardly be can considered an agreement in common understanding, so much the more as the other actual facts of its advent are unknown (for example, there is no knowing if a counter document of the other party exists and if there was taken any action in performance of the agreement concerned).
The next stage of the procedure for disposition of participation interest in limited liability charter capital until June 1, 2009, is company notification on disposal taken place. According to Art. 21.6.2 of the Law on LLC «the acquirer of a participation interest or a portion hereof assumes the rights and obligations of a company participant upon the company notification on the disposition concerned». The only legal requirement to this notification is its written form. Neither the party which has an obligation to notify – assigner of a participation interest or acquirer, nor the notification terms or its exact tenor, or notification procedure – for example, whom it is to be addressed, - are not specified. Moreover, the judicial practice often does not require the very availability of the notification concerned as a separate document, it assumes if a company has somehow found out the disposition executed it is not authorized to disacknowledge the acquirer as its participant. As a result, for example, in case when one of the parties is a person simultaneously vested with authority of a company sole executive body the notification deems executed directly upon the execution of disposition of a participation interest agreement.
The next step is the recording of the changes in company participants to the Unified State Register of Legal Entities (the USRLE). Pursuant to Art 5.5 of the Federal law «Оn State Registration of Legal Entities and Individual Entrepreneurs» (hereinafter – Law on Registration) within three days upon the recording of company changes the latest notifies the registration authority, i.e. the territorial authority of the Federal Tax Service of Russia. The notification procedure is similar to the procedure provided for the USRLE recording of changes which are not connected with changes in legal entity constituent documents, i.e. an application on registration (R 14001 form with G and D pages filled respectively for legal entity and individual LLC participants) by the total number of company participants, the prior as well as new ones, is filed to the registration authority. The application is submitted by company executive whose signature on the application is notary certified.
Finally, the final chord is the recording of changes to the company constituent documents, which pursuant to Art. 12.1-12.2 of the Law on LLC must provide for the composition of the company's participants, the size and the participation interests' nominal value in company charter capital. The changes concerned are recorded in general procedure, i.e. through calling of the participants' general meeting which decides on amendment of the constituent documents by a qualified majority. Herewith, pursuant to Art. 12.4 of the Law on LLC, one more registration is required – now the registration of changes connected with the amendment of the legal entity consitituent documents. It is executed through filing of application (R 13001 form), decision on amendments and text of amendments by the executive. Contrary to the first registration the state duty is payed, consequently the required documents set includes the payment receipt.
Problems Until July 1, 2009
This is the ideal depiction of the procedure for disposition of a participation interest in LLC charter capital until July 1, 2009 subject to entire understanding of all the participants and default of anyone's counteracting. However such a situation is really rare. The law in its nature, likewise any social regulation system, is initially inherent of possibility to be breached, possibility of actions contrary to the regulatory prescriptions and the figure of legal regulation merit is, first, the effective prevention of such violations, second, as less effective reaction to them for the purpose of adjustment of factual circumstances to legal requirements.
Neither from one, nor from the other point of view the prior system is satisfactory.
First of all, a clear determination of the event the property transfers from one person to another serves prevention of violations in course of disposition of participation interests in LLC charter capital, i.e. the moment the assignor ceases to be a participant while the acquirer becomes it. In theory, any assignment procedure stage described above can be considered as such event – execution of agreement, company notification, registration in the USRLE of the changes to the composition of participants, as well as the recording (or registration as the fifth possibility) of amendments to the constituent documents. Furthermore, with due consideration of the registration public character the laymen usually attribute to the very recording in the USRLE a crucial significance for determination of the composition of the company participants, therefore, the registration is fundamental.
However the legislation in effect until July 1, 2009, significantly limits the list of circumstances to which the transfer of a participation interest in charter capital can be connected: on the assumption of the provisions of Art. 21.6.2 of the Law on LLC already cited it could be supposed that the participation interest is transferred upon the execution of assignment agreement or upon a company notification on it. A simple reasoning attests in favor of the second interpretation, notably what is it a right which cannot be exercised and, consequently, as far as a participant exercises his rights upon the notification, he is not considered as participant until the very moment. However, the arguments in favor of the first point of view appear more convincing. Thus, the grammatical interpretation of Art. 21.6.2 of the Law on LLC suggests that the law requires a notification on assignment already effected, i.e. an assignment which took place prior to notification. Furthermore, Art. 48.2.2. of the Civil Code of the Russian Federation directly qualifies the rights of the LLC participant with regard to the company as the rights in personam (even though this statement is not unanimously supported by all the lawyers, however dura lex – sed lex), therefore, the rules for the assignment of obligations shall apply to the assignment of rights concerned. Here the same as for the participation interest in charter capital, the rule-maker distinguishes assignment of claim being effected upon the execution of the relevant agreement, and the moment upon which the acquirer of the right is entitled to exercise his right – it is exercised upon debtor notice on assignment effected (art. 382.3 of the civil Code of the Russian Federation). As follows the situation is totally identical: first the disposition takes place and then there appears a possibility to exercise the assigned right. Thus, the most trustworthy seems to be the statement that a participation interest in the LLC charter capital is transferred from the assignor to the acquirer upon the execution of the disposition agreement. Notwithstanding it is just for any interpretation that without any doubt the transfer has takes place when besides the agreement the company was notified.
Apparently, until July 1, 2009, the next stages such as the recording of changes in the USRLE or amendment of the constituent documents are of no significance for the transfer of participation interest in charter capital. Consequently, the situation is quite possible when a participation interest is already owned by a new participant however the composition of participants in the register rests un-updated due to various reasons, from a trivial disorderliness to conscious refusal of a company executive to disclose the assignment effected to the registration authority, for example, due to personal enmity between him and a participant who sold his participation interest, or the acquirer thereof. Indeed, this executive can incur administrative liability, however it is just an implied influence which provides no protection to the new participant. Although court actions on compulsion to disclose the information to the USRLE are possible, they are quite troublesome, and even more troublesome is enforcement of decisions in these cases.
Even more difficult it is to protect a participation interest acquirer when the other participants refuse to vote in favor of amendment of the company constituent documents. Our legislation does not authorize the compulsion to vote on the general participants' meeting, still further to vote in a certain manner. What is more, even though the acquirer succeeds to record the charter amendments, this does not necessarily mean that he will come off amending the foundation agreement which requires a unanimous vote while amendments to the charter require 2/3 majority. Thus and so a company participant who owns a minimum participation interest can lock up amending the foundation agreement.
Naturally, default of recording of company changes in the USRLE or LLC constituent documents by itself does not entail negative consequences for the acquirer of a participation interest: he becomes a participant upon the execution of agreement and he is authorized to claim the company to honor his rights upon the notice on assignment effected, nevertheless, first, this situation may cause trouble for a company itself, for example, in course of communications with counterparties which are likely to find a contrariety in the constituent documents and the USRLE extract, thereby, put in doubt the company's credibility. Second, it can entail a situation when a company charter provides information on the participants' composition which is neither in compliance with the foundation agreement nor the USRLE extract or information in company's notice, while in effect a participation interest is assigned once more and the assignor and acquirer of a participation interest only possess the actual situation (if complicated by the fact that the constituent document exist both in registered and unregistered versions the situation turns out to be entirely kafkian). As a result, any person intending to purchase a participation interest in LLC charter capital is never certain the participation interest assignor is an actual owner authorized to dispose thereof. Some difficulties are caused by a simple written form of participation interest disposition agreement: in view that rarely an expertise founds the actual date of the agreement execution, there is a vast possibility for backdating fraud with agreements and other documents (for example, company's notice).
Evidently the situation required to be adjusted and it only sets wondering that such a law appeared that late. Let us examine the efficiency of rules which are in effect upon July 1.
Procedure for Disposition of Participation Interests after July 1, 2009
The most significant novel of the Law №312-FZ is introduction of obligatory notary certification for participation interest in LLC charter capital disposition agreements. An obvious advantage of notary form is a higher publicity level of agreements, their obligatory recording in notary registers, and consequently – elimination of backdated agreement execution (unless considering the entirely criminal notary forgery or conspiring with notary), as well as notary examination of agreement's legality, therefore – a certain guarantee from challenges of their legality on the ground of inconsistency with law.
However, at the same time the notary form entails some negative effects. The most evident is cost increase for disposition procedure as now the persons willing to dispose of a participation interest in charter capital bear the notary charges. Furthermore, some problems a re likely to arise if a participation interest disposition agreement provides for certain non-standard clause consistent with the current law but diverging from the ordinary, for example, complex payment or security terms, mixed nature of agreement which in addition to obligations related to disposition can provide other obligations. Notaries which incur unlimited liability may for some comprehensive reasons may prefer to avoid examination of the agreements' legal niceties and simply refuse to certify this type of agreements, the existing system of challenging refusals in notary certification is quite ineffective as far as it is almost impossible to get a notary order on refusal required for the challenge. In these conditions from one side, it is possible to assume an increase in demand for the services of the notaries who are not afraid to deal with the complex agreements and certify them, and from the other side, expect a transition to the double document processing when the parties execute an elementary scope disposition agreement to be notary certified while the actual relations of the parties are regulated by other method - through various gentlemen agreements without remedies, bills of exchange or promissory note schemes and other ambages. It is not that awfull by itself provided the notary form of participation interest disposition agreement achieves its objective and ensures the unreserved validity of this agreement eliminating any fraud techniques, still as we will see later, it is the very objective which is failed to be achieved. But before approaching this issue let us finish with the procedure for disposition of participation interest according to the new regulations which are in effect upon July 1, 2009.
It is necessary to note that the current Art. 21.12 of the Law on LLC now explicitly provides a participation interest in company charter capital is transferred to the acquirer upon the notary certification of the disposition thereof agreement, and just in cases which do not require notary certification (for example, acquisition of participation interest by company when so provided for in the Federal law, and distribution of the participation interest owned by the company among the company participants) – upon the recording of the relevant changes in USRLE. Thus, all the successive actions related to the transfer of the participation interest in no manner affect the legal succession, they only fix and asserts the position of the acquirer.
What are these actions? Pursuant to the current Art. 21.14 of the Law on LLC within three days upon the notary certification of participation interest disposition agreement the notary on its own discretion submits the changes in a company participants' composition to the registration authority through filing the application signed by the assignor and the documents on the basis of which the transfer of the participation interest is effected. Apparently, this application has to be similar in outline to the application of R 14001 form, however, evidently the rule-maker changed his approach to the applicant on changes: it is not the executive anymore but the participant himself disposing of his participation interest. This provision eliminates the discretion abuse of executive which could previously obstruct the recording of changes in the USRLE. However, it is obvious that due to the change of the applicant the ancient R 14001 application form is no longer applicable, while as this article is being prepared – two weeks before the changes come into force - there is no a new form asserting the legislative changes yet. If the Government of the Russian Federation fails to amend its Order №439 dated June 19, 2002, as of July 1, 2009 the circulation of the participation interests in LLC charter capital will be disabled.
In addition to disclose the changes on composition of LLC participants to the registration authority, the notary within the same three days shall direct the same documents to the LLC in order it introduces amendment to the company participant register maintained by it. This register being a new institution of the national legislation as well introduced by the Law №312-FZ will replace records of the company participants in the company's constituent documents since upon July 1, 2009 the information on the participants is no longer in the obligatory scope of LLC charter. This implies one additional positive novel of the Law №312-FZ: upon July 1, 2009 neither the decision on amendment of the LLC constituent documents nor the subsequent registration is required in event of the disposition of participation interest in charter capital thereof occurs – with connection to amendment of the company's constituent documents, therefore, there is no need to pay the state duty required until July 1, 2009 for the registration concerned.
Upon the recording of the entries to the USRLE and the company participant register maintained by the company the procedure for transfer of participation interest proceeds to completion. The situation depicted is once more an ideal one pursuant to the legislation in effect upon July 1, 2009. And yet, the scrutiny in examination of legislative novels reveals a lot of problems entirely ruining the positive effect which could be brought by the Law №312-FZ in the regulation of the relevant relations.
Problems Likely to Appear Upon July 1, 2009
Let us recall the problems underlined earlier. Foremost, it is the appreciation and sophistication of the procedure of participation interest disposition due to the notary certification of the agreement of disposition thereof. Second, it is default of proper organizational support for the new procedure of registration of changes in the USRLE, namely – default of the new registration application form.
However, the ideal would be the situation limiting the range of the law enforcement problems to the list specified. Alas, that is not true.
First, the Law №312-FZ introduces the transitional provisions which are absolutely inadequate to the precedent regulation. Thus, pursuant to the Art 5.5 of the Law №312-FZ, the registration authority concurrently to the registration of amendments to the company charter due to its bringing to conformity with the Law №312-FZ records in the USRLE the information on the composition of the company's participants based on the foundation agreement thereof as the lately revised and registered. Art. 5.7 provides that until the LLC constituent documents are brought to conformity with the new requirements, one's authority for disposition of participation interest in company charter capital are confirmed by the company charter in the latest registered revision thereof.
Even without taking into consideration the apparent contradiction between these two provisions (in the first case the information is based on the foundation agreement, in the second – on the charter; what to be done when the disposition has been effected upon July 1, 2009, the foundation agreement is no longer a constituent document and, respectively, the amendments thereof are no longer registered, while the charter is amended with respect to the composition of the participants but not with respect to its bringing to conformity with the Law №312-FZ, in other words, there is an obvious situation when the charter is in conflict with the foundation agreement?) the relevant rules directly are in contradiction with the procedure for disposition of participation interests until July 1, 2009. Let me remind, as already pointed until July 1, 2009 the participation interest in company charter capital is transferred to the acquirer upon the execution of disposition agreement, at the very outside – upon the company's notice on the disposition effected, the recording of changes both in the USRLE and each of the constituent documents is just an attendant circumstance with has no influence on the status of the acquirer as a company participant. The composition of the LLC participants is in no way governed neither by the charter, nor the foundation agreement.
In effect, the transitional provisions of the law deprive of property those LLC participants who acquired their participation interests in charter capital following the due procedure while the information on them for a number of reasons has not been recorded in the company constituent documents or at least the foundation agreement (let us recall, for this situation to occur it is sufficient just one of the participants – even the most minority one - opposes the disposition for any reason, from simple laziness to conscious sabotage). I believe, in this case we can manifestly insist on Art. 5.5-5.7 contradiction to Art. 35.3 of the Constitution of the Russian Federation which prohibits one's deprivation of property. Congratulations to the rule-maker, he founded a perfect basis for corporate blackmail or so-called greenmail, when the minority LLC participants "sell" their consent for amendment of the constituent documents to those participants who have legally acquired their participation interests a long time ago without being recorded in the constituent documents for any reason. As an alternative could be considered a lengthy and expensive judicial proceeding for contesting of the information recorded in the constituent documents, in course of which the potential acquirer the most possibly gives up with the idea to execute the respective agreement.
Even this problem is not that terrible as it relates just to the transition period. The mischief of the new law is hidden in its system contradictions which offer great opportunities for new practices of the fraud.
One of the primary objectives for introduction of the notary certification for disposition of participation interests in LLC charter capital and the USRLE public credibility was fighting fraud of continuous sales of the same participation interest to several buyers. Really, it seems very easy to be performed on condition of a simple written form and a participation interest transfer upon the execution of the respective agreement. The notary form at least allows to establish the date the agreement is executed.
Nevertheless the revised law provides that a notary verifies the powers of the person disposing of a participation interest for the respective disposition. Allegedly it will discourage the disposition of participation interests by the persons which do not owe them. However the law introduces quiet a strange rule for evaluation of the assignor's powers to dispose of a participation interest. Art. 21.13 of the Law on LLC explicitly lists the documents to be confirmed by the notary, including: (1) participation interest acquisition notarized agreement and an extract from the USRLE, or (2) duplicate copy of the notarized agreement and an extract from the USRLE, issued not earlier than ten days prior to the date of the visit to the notary for the purpose of notarizing the transaction, or (3), in the event when notarization of the previous transaction was not or is not required – a document evidencing the transfer of the participation interest and an extract from the USRLE, issued not earlier than thirty days prior to the date of the visit to the notary for the purpose of notarizing the transaction, or (4), in the event when a participation interest is disposed by one of the LLC founders – document on company foundation (decision of the sole founder on foundation, notarized copy of the foundation agreement) and an extract from the USRLE, issued not earlier than thirty days prior to the date of the visit to the notary for the purpose of notarizing the transaction.
Apparently it is supposed that the principal case will be the one provided under number 1; on the basis of the notarized copy of the agreement under which a participation interest was acquired the notary puts on the agreement a mark on the disposition executed, whereupon it is impossible to dispose of the same participation interest using the same agreement. Thereby the participation interest acquisition disposition agreement acquires the characters appropriate to securities – the first as the second are enforceable on presentation.
However the legislator did not further pursue the assimilation path for a participation interest disposition agreement and securities (one must suppose, it is a right decision), and provided for disposition of participation interest upon other documents. And right here there is a possibility for fraud. Let us consider, for example, the situation described under number 2. The number of document's notarized copies possible to get is illimited. The same is for the extracts from the USRLE – one may have them as many as he wishes. Thus, the fraudster willing to make multiple sales of owned by him participation interest is free to effect them until the registration authority receives the information on the change of a participant. During this time, evidently, being unlikely to notatize the successive disposition of a participation interest with the same notary, he is free to do it with the neighborintg notary. Therefore, the possibilities for fraud are limited just by the fraudster's physical capacity to replace from one notary to another.
It turns out that to commit fraud he disposes of at least that ten days within which the extract from the USRLE can be issued, plus all the time the notary information reaches the registration authority, and it is three days provided to the notary under the law, as well as the mail delivery time (the law provides for the personal presentation of the documents to the registration authority as well as mail and currier delivery – unlikely the notaries will queue in the tax bodies). If added that participation interest disposition agreement can be notarized in Kaliningrad while the company and the registration authority are seated in Petropavlovsk-Kamchatsky, the uncertainties period (the time gap between the date of transfer of a participation interest, i.e. the agreement notary certification, and the registration date of the entry to the USRLE) goes pear-shaped. Even more lengthy this period is in situations marked 3 and 4 where the rule-maker authorized the extracts from the USRLE aged thirty years.
Therewith a participation interest deems transferred to the acquirer which executed the agreement earlier. However it is not absolutely true that his documents will reach the registration authority first. Apparently the registration authority having received the first set of the disposition documents records the respective changes to the USRLE and later it will refuse to register the other documents on the disposition of the same participation interest by the same person it receives grounded that the assignor has no powers anymore to dispose according to the register (this new ground for refusal in registration is also being introduced by the Law №312-FZ). Therefore, if the documents of the first acquirer arrive later he will be also refused of registration however being an actual participant of the company. Here the good faith purchase tools would start to work if we addressed this issue within the framework of the present article. In any case the decision chosen by the rule-maker predetermines the revolving disputes which participants having notarized agreements will all the more believe in legal validity of their pretensions. However, we have seen that even the most scrutinious compliance with the law secured by the notaries and the registration authorities does not allow to eliminate multiple sales.
The way to avoid it could be to subordinate the transfer of a participation interest to the recording of the changes in the USRLE by parity of reasoning with regard to the realty rights. Nevertheless due to unknown reasons the rule-maker did not follow this path. It is possible to suppose the notaries could also obstruct multiple sales through establishment of real time assignment information system within the notary community. And still aside from the technical and organizational difficulties there is a legal obstruction: the law expressly provides for the list of the documents evidencing the right to dispose of a participation interest in charter capital, and any other requirements originated by the notary even from the best of motives are illegal. Moreover, such requirements violate the rights of the good faith participants of the civil circulation.
If so, until the problem is ultimately resolved by law we advise the acquirers of a participation interest in LLC charter capital should more scrutiniously get the lowdown of the companies the participation interests of which they are going to acquire, and purchase the participation interest just against the assignor's presentation of the original notarized document evidencing the acquisition of the participation interest to the notary; although the next several years for an obvious reason there won't be many of those.