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Bankruptcy as a Mean To Surmount the Crisis

When a company's financial standing reaches its critical state the bankruptcy can be the only solution.

Alexey Filippov

Alexey Filippov
Former associate

The Bankruptcy Is Not That Terrible...

It is a far cry from the days when an insolvent debtor was cut off and given to the creditors. In the world practice the sense and spirit of the bankruptcy is not that of destroying the company but providing with a second chance for a company to released itself from the burden of debts and continue its operations. Whereby the company deems not a legal entity with a specified registration or tax number but a separate property complex of economic significance.

The national bankruptcy laws were drafted with due account of world patterns. They are also based on necessity of preservation of assets and work places. Therewith they aim protection of interests of a company's creditors providing for satisfaction of their claims from the property of a company-bankrupt.

The expediency consideration for the use of bankruptcy as a means to surmount the crisis shall take into account the particular activities of the company, its size and structure of assets including the amount of outstanding claims.

Developers are professional companies providing services on property project development, creation of professional team, fundraising, project implementation and usually its further development. Nevertheless sometimes it happens that either the project implementation turns out to be impossible or competed project is encumbered with financial obligations that a developer is faced with an issue of project rollback or entire restructuring of business for the purpose of release from the creditor claims including numerous shareholders who have designs on project.

As a textbook example can be taken construction of street railway in New York in the early XXth century. In purpose of raising the funds for the project developers founded several joint stock companies issuing stock and took out numerous loans. Indeed, the fundraising was followed by promises of chimerical dividends and statement of fantastic profitability of street railway service. The funds raised covered the costs of construction, purchase of cars and introduction the street railway service into operation. However the project profitability turned out to be not that expected high and the investors claimed the promised profits. Then all the joint stock companies declared themselves bankrupts. Eventually all the bank loans were written off, the shareholders found himself in the situation on MMM investors and the property complex was transferred to other companies behind which back stood the same developers.

According to the Russian laws the bankruptcy applies solely to legal entities and individual entrepreneurs. The bankruptcy is formalized only by arbitrazh court procedure. To meet the constituent elements of bankruptcy a company shall have outstanding debt obligations in amount exceeding 100 000 rubles (for entrepreneur – 10 000) and evade it debt in excess of 3 months.

Application on bankruptcy can be filed to arbitrazh court by a debtor himself or his creditor. A debtor shall file the application in event it is established that the amount of assets does nor allow satisfaction of all the company creditors. Voluntary application on bankruptcy is allowed only upon adjudicated debt and payment delay. The arbitrazh court initiates the bankruptcy procedure upon the application. Thereafter the procedure is the same.

Arbitrazh Administrator

Upon allowance of claims the court applies the first of the bankruptcy stages – supervision – and appoints an arbitrazh administrator.

It stands to make a detailed examination of role of arbitrazh administrator. He is a key figure in the bankruptcy procedure. It depends mostly on him which conclusion upon financial analysis is presented to the court and if the constituent elements of bankruptcy are available. He decides on availability of premeditated or fraudulent bankruptcy elements, contests the debtor's deals, takes measures to collect debts from the third parties, formalize the debtor's titles for realty and land plots, claims bringing to responsibility a company chief executive and founders (shareholders), disposes of a debtor's property.

Arbitrazh administrator's activity is strongly exemplified in bankruptcy case of «YUKOS Oil Company» OJSC, when one of the major Russian companies was declared bankrupt for tax liabilities which amount expressly allowed the company to satisfy the debt, however no such attempt was undertaken. Therewith, disappearance of YUKOS as a legal entity did not entail the liquidation of its assets. Rosneft became the YUKOS's "successor".

In bankruptcy event it should be taken into consideration that an «unfriendly» arbitrazh administrator involved by a company's creditor in the first place protects the interests of a particular party and not those of the company and its owners. Eventually the company risks to loose its assets and business and its managers and participants (shareholders) risk to find themselves debtors (they incur vicarious liability in event there is a deficiency of company property to pay in full all claims).


As it was already pointed out the first of the bankruptcy stages is supervision. On its results the decision of the company's future – shall it be declared bankrupt or its solvency can be restored. As the practice indicates in 95% the supervision immediately passes to the next bankruptcy stage — competitive procedure. For the rest 5% the external control is applied. However it serves only to delay a process as the external control again is completed by competitive procedure. The chances for bankruptcy to be completed by supervision and all the more external control are rather rare. Due to this in event the hostile actions of the creditors are taken place they are preferred to be solved before the bankruptcy is applied as the completion of the procedure when the arbirtazh administrator is appointed by a hostile creditor causes many difficulties.

Competitive Procedure

Competitive procedure is applied on the results of bankruptcy hearings. The company is declared bankrupt. Company management is removed, the owners loose entirely their right to decide on the future of the company and its operations. All the powers are transferred to the arbitrazh administrator and general meeting of company creditors which were listed by arbitrazh court in a company's creditor register.

In course of competitive procedure the assets are sold at a public auction, and the claims of the competitive creditors are satisfied with the auction proceeds. Formation of the bankruptcy estate, its appraisement, sale and allocation of proceeds are within the competence of atbitrazh administrator. Therefore, only the bulk sale of the assets, as a separate lot, is allowed on this stage (the way it happened to YUKOS assets). It is also possible to restructure the assets of a company-bankrupt when the assets in their entirety are contributed to charter capital of other company (joint stock company), thereafter the stock of a newly formed company is put up for auction and not the bankruptcy estate. Such a whole sale lot or formation of new company allow to preserve the property not as a broken set but integral asset complex with its internal structure often preserving the team of specialists operating the complex.

Satisfaction of Creditor Claims

Cash proceeds from the company assets sale are distributed between creditors according the provided order of priority with some exceptions. The first priority are claims by individuals for harm caused to life or health, the typical example are company employees suffering employment injuries. The second priority claims are employment and authorship agreement claims. The third priority claims are the claims of the other creditors including but not limiting to tax authorities claims, claims relating to purchase-sale, supply, works and services, credit and loan agreements. The third priority claims include as well all the fines and penalties arising out of the contract breaches. In event if the amount of bankruptcy estate is insufficient to satisfy all the claims, the claims are satisfied pro rata with observance of established priority ranking. In other words if an arbitrazh administrator lacks money all the employees even to pay all the company employees, the proceeds will be distributed among all the employees pro rata to the amount of their claim. In this case the third priority creditors will get nothing.

However if there is a rule there is always an exception to it. One of the principal exceptions to this rule which expressly secures the interests of the credit institutions make the particularities for distribution of foreclosure sale proceeds. In event of foreclosure sale not less than 70 % of proceeds are payed to the pledge holder, and when a loan agreement is secured by pledge a pledge holder being in the most of cases a bank is payed not less than 80 % of the sales proceeds for the pledged property.

The similar exception make the current payments of a company – bankrupt. Current payments include contractual and tax obligations that have arisen upon the bankruptcy case is initiated by court. Such obligations are discharged as priority claims before all. The reason for that is necessity to ensure a company operating during the bankruptcy procedure, including the period of assets replacement (formation of a joint stock company), formation of competitive lots and conduct of auction. The principle used here is clear to anyone who was engaged in real production – attention value of an "operating" enterprise (precast concrete factory, for example) is much higher than those of an idle enterprise with cement which has hardened directly in concrete mixers.

Competitive procedure and bankruptcy procedure is terminated when all the company assets are sold and claims are satisfied from the proceeds.

Claims that were not satisfied in whole or in part due to insufficiency of company assets deem discharged. It means the creditors are no longer authorized to submit claims and indeed it is impossible as upon the realization of company assets and completion of bankruptcy procedure the debtor is winded up. Moreover it applies to all claims including but not limited to supply, production payments, performed services and works, loan and credit agreements, remuneration for employment agreements etc.

The rights of the former company owners (participants, shareholders) arising out of participation interest or share ownership also terminate. Because it is impossible neither to own nor manage a winded up company.

Reputation Risks

Oftentimes the business owners are interested in bankruptcy procedure not just as in a means of release from debts and other company owners but also they see it as a way to preserve the business and turn over a new leaf. In this situation scandals and mutual accusations of corporate raid, hostile takeovers, and all the more ordinary fraud and creditor scam can invoke significant negative effects.

As practice proves one of the most efficient measures to «save one's face» is transparancy of the procedure, due disclosure of ongoing procedure (naturally within due limits). One of the main reasons for the public and regulatory authorities' attitude to bankruptcy procedure is a company liquidation and, as a result, dismissals, outstanding salary arrears and to some extent outstanding tax obligations. As a rule debts to creditors – legal entities and entrepreneurs which have arisen out of contractual relations do not cause a significant negative response. Eventually the business activity is conducted by commercial structures to their own risk and peril. If a company fails to act with a due circumspection while choosing a counterparty, it is a problem of the specified company. Therefore, if the interested parties are informed on upcoming reorganization of a company – bankrupt via formation of other companies on the basis of its assets and placement of its former employees in newly formed companies, it will positively affect negative attitude.

Indeed, in practice disclosure of information may not result in desired effects. Therefore, if possible the interest parties shall be distanced from bankruptcy procedure being brought to the forefront just on the completive stage when the new companies are already founded and it comes to continuation of production.

When the only objective of bankruptcy procedure is liquidation of indebted company (a company with no or insufficient assets) the key to save face is preliminary work on company preparation to bankruptcy procedure. During the preparation stage the parties in interest are distanced from company (dismissed from their positions, selling their participation interests and shares), new companies are founded, claims of the amicable creditors are satisfied, agreements are terminated or re-executed, remaining assets are realized, debts are recovered or sold as choses in action, etc. As a consequence bankruptcy procedure will not affect the parties in interest and a company – bankrupt won't be attractive as a target objective of an information or any other attack due to the total absence of assets.


The apparent good of bankruptcy procedure for a company – bankrupt is writing of all of its debts which were not discharged in course of competitive procedure. No other procedure does not allow to be legally released from debt responsibilities. In case of accrued costs of employment remuneration and payments to the Pension Fund – it is the only means to wind up a company.

The bad of the procedure is its lengthy duration – about one year although often bankruptcy procedures last for years.

As a rule the developers do not face the issue of bankruptcy procedure as the assets of such companies significantly exceed the costs of bankruptcy procedure.

Considered all it is likely to expect bankruptcies of several developers of the Ural region. The most last months high-profile case is that of «Uralstroy-1» OOO bankruptcy (presently in competitive procedure) which was effecting development of several residential districts in Ekaterinburg. It remains to wish the developers in event of crisis situation not to wait bankruptcy procedure is initiated on application of hostile creditors but themselves undertake steps to preserve their company and its assets.

Bankruptcy, Corporate Law

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