Fighting for the Property of the Debtor
How to verify that the claims of a suspicious creditor are reasonable?
In many cases, a delay arising for a debtor in respect of one obligation causes a "domino effect" and entails new debts arising over and over again. A loss-making supply to one of the clients results in delayed payment to the supplier of the goods. In turn, the growing liquidated damages to suppliers result in failure to meet the deadlines for bank loan repayments. A similar situation also arises for individuals.
The number of creditors is getting higher, with debts to them growing – and there comes the point of no return when the debtor understands that he won't be able to repay all of his debts from his ordinary income. For a bad-faith debtor, it is at this time that a pool of fictitious debts which do not exist in reality arises and grows quickly. Fake receipts, unjustified sureties, lease agreements for unnecessary premises spring up to protect the debtor's property, with the creditors' hands already reaching out for it. A masquerade commences where a person acting for the debtor's benefit can be hiding behind the mask of an ordinary creditor.
In this fight over the debtor's property, good-faith creditors should be able to distinguish "real" creditors from "unreal" ones that are friendly to the debtor. Otherwise, the bigger part of the debtor's property will pass through the hands of his associates and return to him.
What aspects should a good-faith creditor pay attention to if a debt claimed by another creditor for inclusion in the register of the debtor's creditors' claims seems to be suspicious? INTELLECT's Senior Associate Anatoly Zazulin explains.
Stage I. Verifying the Creditor's Legal Identity
The most frequently encountered method of creating fictitious creditors is involving the debtor's affiliates or relatives as such creditors. As per Article 4 of the RSFSR Law "On Competition and Limitation of Monopolistic Activities in Commodity Markets", the affiliates of a company or entrepreneur shall include:
- the persons forming part of the company's executive bodies (director, member of the board of directors) as well as their close relatives;
- the shareholders or members of the company owning more than 20% of the voting shares or equity stake in the authorized capital;
- the legal entities in which the debtor owns more than 20% of the voting shares or equity stake in the authorized capital; and
- the persons that, together with the debtor, form part of one business and industrial group: subsidiaries, other holding members, and their controlling persons.
If reference is made to individuals, the following persons shall be recognized as affiliated (interested): debtors' spouses (or former spouses if the marriage was dissolved shortly before the creation of debts), ascendants and descendants, sisters, brothers and their descendants, spouses' parents, children, sisters, and brothers (paragraph 3 in Article 19 of the Federal Law "On Insolvency (Bankruptcy)").
The presence of the debtor's affiliates in the list of creditors is the first sign of such creditors being fictitious. At the same time, many debtors realize it is fairly easy to expose affiliation and use persons that are formally unrelated to them. This practice helped actively use such creditors for a long time; however, in recent years, the courts have developed criteria allowing their status to be challenged. Thus, in its Ruling No. 308-ES16-1475 dated June 15, 2016, the Russian Supreme Court accepted a broad interpretation of the affiliation concept. It pointed out that affiliation could be of factual nature, without the existence of formal legal connections between the persons.
In another Ruling, No. 308-ES18-2197 dated July 13, 2018, that principle is developed further: in reversing the judicial acts of the lower-instance courts, the Supreme Court pointed out that, albeit the debtor and the creditor possess no formal affiliation signs stated in the Law "On Competition", the community of their economic interests clearly indicates that such affiliation is actually in place.
Such community of interests may consist in that:
- the creditor carries out the same activity as the debtor – for example, runs a restaurant business;
- the creditor and the debtor permanently closed various transactions on other than usual market conditions – for example, loan agreements without any security; and
- the creditor and the debtor acted as co-borrowers or sureties for each other's obligations before third parties.
Sometimes, the relations between the creditor and the debtor are hidden behind the "corporate veil" of offshore companies, with it being impossible to obtain information on their beneficiaries from any open sources or foreign jurisdictions. In such cases, the position of superior courts is applicable introducing the following presumption: if an offshore company has failed to disclose information on its ultimate beneficiaries to prove that it has no ties with the debtor, it shall be recognized to be its affiliated organization.
A sign of the creditor company's cover-up nature may also be the fact that it was established immediately prior to closing the transaction giving rise to the creation of the debt.
Stage II. Verifying the Economic Feasibility of the Transaction
A distinctive feature of fictitious transactions used to create fictitious creditors is a mismatch between the parties' stated will and internal will. That is, in case of a fictitious transaction, the objective of the parties (for example, creation of a non-existent debt) differs from that stated "on paper". As indicated by the Supreme Court on more than one occasion, when challenging the creditor's good faith, it is sufficient to ascertain the fact that, when closing the transaction, the creditor and the debtor had no intention to perform that which is spelled out in the legal documents used to execute the transaction.
The fact that the transaction has a flaw shows through even with the documents, certificates, and consignment notes that have been drawn up completely, correctly, and neatly and are intended to substantiate the legal status of the debtor's friendly creditor – when carefully comparing the actual circumstances of the case with how everything was executed.
Therefore, after the creditor itself has been looked into, attention should be paid to the essence of the claim that it makes to the debtor. The following signs may be indicative of the transaction being fictitious:
1. No economic viability of the transaction being made.
The main principle of entrepreneurial activities stated in paragraph 3 of Clause 1 in Article 2 of the Russian Civil Code is deriving a profit. Thus, it is presumed that the normal and good-faith behavior of a market participant is acting for his/her/its own benefit with the purpose of deriving an economic benefit. As for a fictitious transaction, it makes no sense from the perspective of the market and yields no positive result to the debtor. This can be evidenced by the debtor acquiring what is known as non-liquid or non-core property.
For example, it was ascertained under case No. А32-43610/2015 that the creditor had delivered a shipment of goods (sunflower oil and seeds) to the debtor, and the debtor only partially paid for the goods; as a result, a debt was created. The delivery was confirmed by taking-over certificates, consignment notes, and reconciliations of mutual accounts. In this connection, the courts acknowledged that the debt was real. In reversing the acts of the lower-instance courts, the Supreme Court, in its Ruling No. 308-ES18-2197 dated July 13, 2018, pointed out that the transaction made had the signs of being fictitious, since, in particular, the buyer debtor did not carry out activities related to the manufacturing and sale of sunflower oil and seeds, i.e. those goods were non-core for it and, therefore, unnecessary.
A similar conclusion was made by the Supreme Court also in its Ruling No. 305-ЭС16-2411 with regard to case No. А41-48518/2014 taking note of the fact that the debtor to which a large volume of meat products was delivered did not carry out any activities to sell meat, all the more so, to the extent stated in the consignment notes.
Economic viability may also consist in the debtor receiving a knowingly non-liquid consideration – for example, assignment of unrecoverable accounts receivable, doubtful bills of exchange, or non-quoted securities. Thus, it was ascertained in case No. А78-6724/2013 that, as a result of doubtful transactions, the debtor forfeited the right of claim to a continuing company in exchange for the right of claim to another company which is bankrupt. The said circumstance served as the basis for declaring those transactions invalid.
2. Obvious Absence of Actual Possibility to Perform a Transaction.
The same Ruling of the Supreme Court, No. 308-ЭС18-2197 dated July 13, 2018, among the circumstances pointing to the transaction being fictitious, noted the debtor being unable to ship the the volume of products supplied because it did not have the relevant warehousing and production premises. In addition, according to the consignment notes, the agricultural products were delivered to the address of a business center rather than an industrial base.
In this connection, a significant role is played by the debtor or the creditor having an actual, not a formal, possibility to perform the transaction. If products are allegedly supplied to the debtor, the debtor should have appropriate personnel, equipment, and premises for making the shipment of the goods (own or hired). If the creditor leases out the property, it should exist and be at the creditor's disposal at the time of the transaction being made.
When searching for such circumstances, one should remember that the devil is in the detail. As an example, a separate bankruptcy dispute can be mentioned which, among other things, challenged the goods delivered to the debtor being real. The courts noted that the consignment notes allegedly confirming the delivery made to the debtor being real specified an automobile leased out by the creditor to the debtor. Thus, an irrefutable doubt presented itself to the court that both contracts were real: either the creditor could not use the automobile to deliver the goods or the debtor could not use the automobile leased out to it.
3. Use of Alienated Property by the Seller.
A major part of invalid transactions is accounted for by property sale contracts performed only on paper – by formal execution of taking-over certificates. In such cases, having legally sold the property to the debtor, the creditor de facto continues using it, while the legal change of owner pursues only one objective – creating an artificial debt in payment for the property.
The following documents executed after the date of the controversial contract can serve as proof of such creditor behavior:
- certificates of examination of commercial real estate confirming that the creditor rather than the debtor carries out activities in it;
- compulsory civil liability insurance policies for vehicle owners in which only persons related to the creditor are stated as the persons allowed to drive the vehicle;
- reports and certificates of administrative offenses confirming the fact of the creditor holding the property sold; and
- slips, receipts, and payments evidencing that the creditor incurred expenses for the upkeep, security, and repair of the property sold to the debtor.
It should be noted that if there is proof that the seller creditor maintained control over the property, the fact of the state registration of the property rights does not prevent the transaction from being qualified as fictitious.
Stage III. Checking the Procedural Behavior of the Creditor and the Debtor
Normally, the creditor being friendly to the debtor is always visible when analyzing its legal behavior. Such creditor goes to court with a lawsuit and always wins it through the admission of the lawsuit by the debtor or on the basis of a settlement agreement being approved. Unlike real creditors, a fictitious creditor takes no active actions to recover the debt, levy execution on the property, or challenge the debtor's transactions. Its role is limited to formal voting at the meetings of creditors which, naturally, is driven by its main objective – to "muffle" the voices of other creditors with the size of its claims to the debtor and to steer the bankruptcy on the right course.
Here, the following moments can be singled out to pay attention to:
- the creditor's claim is admitted by the debtor;
- the creditor's claim is filed to a lesser extent than contemplated by the obligation;
- before the debtor's bankruptcy, the creditor did not attempt to recover the debt by enforcement nor presented any writs of execution to the banks or the Federal Bailiff Service of Russia; and
- the creditor's procedural position being passive (does not initiate the challenging of transactions, does not participate in court sessions).
*** The proposed staged plan to look into a suspicious creditor will not only help detect the debtor's friendly creditor but will also help put together an exhaustive list of arguments and evidence confirming the fictitious nature of its claims. Meanwhile, it should be remembered that the signs of affiliation with the debtor and the creditor's suspicious procedural behavior alone are frequently not enough to declare a creditor fictitious. The main role here is played by the transaction giving rise to the debt being ostensible. The analysis of such transaction should pay a great deal of attention on trivialities and indirect evidence which will help destroy the external impeccability of the transaction.