Corporate and contract law
Corporate and contract law
MIFC Taskforce Statement on the Civil Code Reform Strategy
06.06.2011 / MIFC
The current version of the Civil Code of the Russian Federation (“CC”), with its first two parts adopted in the mid-nineties, broke away from the Soviet civil law, designed to regulate property relations in a planned economy, and laid the legal groundwork for the development of a market economy.
At the initial stages of market economy, the existing civil law was sufficient. However, in recent years the economy has become considerably more complex due to globalization and tougher international competition for investment resources. New business forms, financial instruments and transaction types continue to emerge. These changes are not always “healthy”, however they to a large extent correspond with reformed market economy in the developed countries. Russian companies arrange IPOs, syndicated loans and move into project finance, venture start-ups, booming internet business… The rapidly progressing economy poses new demands that begin to outpace the civil law built from the ashes of the Soviet planned economy. For instance, the service contract – a cornerstone of modern economy – is regulated in the Russian Civil Code by a handful of basic norms in a mere five Articles.
Besides, businessmen today actively use the corporation as a legal structure, key national producers are joint-stock companies, and the state seeks to make Russia more investor attractive, targeting portfolio investors to sell them company stock. This calls for active progress of corporate affairs, while corporate governance practice demands overdue changes in civil law, related to the most acute corporate legislation problems.
The situation would cause less practical trouble if the Russian court practice could quickly come up with correct solutions to the problems posed daily by business and corporate relations. Unfortunately, a number of reasons preclude us from forming a well-balanced court practice within a short timeframe. Many cases meet with hostility and suspicion caused by widespread foreign legal concepts that are news for Russia, leaving contract agreements by equal partners stripped of court protection. Court practice also completely fails to resolve a number of crucial corporate law issues.
The overall situation is aggravated by numerous cases of rather off-hand court approach to business agreement and investor rights protection. As a result, most transactions involving Russian assets migrate to foreign jurisdictions, allowing more legal flexibility and a more predictable – for bona fide parties – settlement of business disputes over complex agreements. Investors, for their part, are withdrawing their funds abroad en masse to invest in jurisdictions with guaranteed investment protection.
The Taskforce is aware that the imperfection of the Russian civil law is not the only reason for investment drain and almost total absence of major investment, financial or corporate agreements governed by Russian law. Absence of faith in the judicial system, tax optimization abuse and other factors are also paramount. And yet one of the deciding factors for exile from the Russian jurisdiction is its blatant inaptitude as a regulative tool for a constantly evolving economy and corporate affairs in the 21st century. This inaptitude carries most of the blame for the fiasco of the Russian law in the global competition of jurisdictions and the failures in the process of forming of an institutional environment to draw investments.
Today, the Russian law either does not allow or sets harsh legal or court practice limits on many widespread contractual instruments such as potestative condition, representations and warranties, indemnity for bona fide actions, waiver compensation and many others. More problems are caused by the rightful concerns from the business side that any attempt to use these civilized, albeit unmentioned in the Russian civil law textbooks, in the absence of clear legal base will trigger rejection and lack of understanding in Russian courts. This is a de-facto ban on large loan and investment agreements, M&A, project finance and many other flagship transactions in the Russian jurisdiction. At the same time, the Russian law and courts ignore many corporate needs, such as dispositive regulation of shareholder relations for joint-stock companies with a small number of stakeholders, allowing a wider scope of possibilities in shareholder agreements, introducing the concept of affiliates and control, ensuring the liability of the controller.
The negative tendency to flee from the Russian jurisdiction is at odds with the creation of an international financial centre in Moscow: Russia must become an attractive jurisdiction in order to develop its financial sector. Stable and predictable law and regulation is key to attractive investment climate. Nevertheless, when the law actually forces the business to migrate to other jurisdictions, hindering economic development, such law should be carefully reformed according to the best international practice and the actual demands of the Russian economy. The Taskforce was not the instigator of the total Civil Code reform we are witnessing. And yet, once the reform has gained critical momentum, a grave error would be to miss this welcome opportunity for pinpoint legislative tweaks that have been long overdue in the Russian contractual and corporate law. These tweaks could at least partially elevate Russian law to the point when the inception of an international financial centre in Russia is possible, paving the way for long-term investment and fostering bona fide business institutions.
We consider the following legislative issues relevant for the creation of an international financial centre in Russia: on the one hand, pushing the ‘do it if it’s not forbidden’ principle in contractual and corporate law – and boosting investor rights protection in the corporate law. The reform will benefit from introducing legal instruments that are widespread in the world’s leading and most popular jurisdictions, where doing so does not contradict the basic principles of the Russian law and the nature of the Russian economy. The competitive edge of a jurisdiction is marked by the scope of legal relations that the jurisdiction can protect; the more primitive, vague and misbalanced the legal side of business, the less it meets its demands – making both the jurisdiction and the prospects of long-term investment in the country’s economy less attractive. The correlation is, of course, not that simple – severely under-developed jurisdictions still attract major investments – however, these are limited to the fuel and energy sector projects, where excess profit mitigates many institutional risks. Attracting long-term foreign or domestic private equity to other long-term projects hugely depends on the safety of such investments and their protection in a friendly legal environment. This is where the imperfections of the Russian contractual and corporate law come to the fore.
Improving the competitiveness of Russia as a jurisdiction, naturally, depends on court practice as well as the law, and progress must be made in both. The MIFC Taskforce standpoint is that enforcement must be developed parallel to law. These two processes must be run and coordinated in sync.
In our opinion, the Civil Code must serve the following functions:
- Simple entry. This is a crucial indicator of investment attractiveness. We see regulation guiding the business towards bona fide standards. Setting entry limits too high not only de-stimulates small business, it also fails its purpose of effectively curbing malpractice.
- Liberalizing corporate affairs for small joint-stock companies and relations for joint-stock companies with a small number of stakeholders, allowing a wider scope of possibilities in shareholder agreements (inasmuch as it does not violate third party rights).
- Building corporate law institutions to protect investor interests, including affiliates and control, the liability of the controller.
- A more consistent implementation of freedom of contract as a constitutional principle in cases where the contract does not affect third party interests or violate the rights of weak parties (consumers, monopoly clients etc.). Equal authority businesses must be empowered with a maximum scope of contractual possibilities, with paternalistic intervention down to a minimum.
- Stronger liability and other penalties for contract misconduct.
In this context, the purpose of the new edition of the Civil Code is to create a business-friendly institutional environment in the Russian jurisdiction. The Civil Code must promote fair play and freedom, and be based on the fundamental laws of market economy (such as free competition, minimum state intervention, free prices, protection of weak contract parties etc.).
We believe that the contractual law norms of the Civil Code, the de facto Economic Constitution of Russia, must stem from the presumption of all parties acting in good faith and having sufficient competence, introducing preemptive measures to stop contract abuse towards weak parties (when one of the contract parties is the consumer, etc.). The same approach should hold for small joint-stock companies and shareholder agreements. We propose recognizing the right of the business to risk their money by entering agreements, and by being liable for the contract and the warranties and representations therein. Excessive paternalism is extremely harmful to the development of business institutions, the forming of a truly free and competitive market. Besides, paternalism sends a wrong message to the parties. At the same time, regulating corporate relations should include the development of investor rights protection.
The progress of Civil Law should become and has the potential to become a boost to the investment climate in Russia by well-judged liberalization of economy and better regulation of corporate relations.
We are certain that the Russian law should reflect the will of Russia to integrate into global economy, draw foreign investors and comply with internationally-accepted business ideals. This is not to say that foreign practices should be thoughtlessly imitated without prior evaluation and positioning in the overall scheme of the Russian law. And still, to ignore market demand and business practice by hiding behind the self-sufficiency of post-Soviet law would be a grave mistake. The legislators, the court judges and the business must unite in the search of effective regulation for the Russian economy, which will be also loyal and friendly towards global capital.
MIFC Taskforce places special emphasis on improving corporate governance standards and minority shareholders’ rights protection. These issues are the most criticized in the Russian financial market. One of our proposals is dividing all joint-stock companies into public and non-public. A non-public company shall be one with minimum shareholders (‘private business’), and its corporate affairs shall be regulated in a dispositive manner. The imperative approach to disclosures and corporate governance shall be retained for public companies. Small companies (up to 50 shareholders, as stated in the Taskforce proposal) that have not been listed, in our opinion, must be regulated liberally – we consider it important to allow maximum freedom of shareholder relations, regulated by the Charter with a maximum scope of shareholder agreements; imperative regulation should be minimal, unless it serves third party interests. For joint-stock companies with a greater number of shareholders, imperative regulation of many corporate law institutions should be developed to protect the minority shareholders.
A reasonable balance should be kept between the interests of majority shareholders (those who control the business and accept the liability) and minority shareholders (as the weak party in corporate relations). We propose to develop corporate law institutions, securities market legislation, improve transparency. To this end, we propose:
a) introducing an updated concept of affiliates, including control laws, instead of the obsolete and inefficient affiliation norms that exist today,
b) introducing the concept of control, instead of the outdated parent and subsidiary norms that exist today, failing to meet modern requirements and ineffectively applied in practice – besides, effective regulation of affiliates is impossible without these norms,
c) drafting controller liability norms: for controlled entity debts, for damages tо controlled entity, for liability to shareholders of the controlled entity,
d) introducing a ban on voting with shares owned by the company or its controlled entities in the Civil Code.The current Russian contract law does not allow a number of widespread business practices, and we propose to amend the law to offer a wider scope of instruments to the business. At the same time, as the market makes progress, new practices arrive and the law should be ready to accept them in the future.
MIFC Taskforce amendments to the legal regulation of transactions and contracts include:
1. Introducing a rebuttable presumption that the contract law norms are dispositive (the norm is presumed to be dispositive unless stated otherwise in the definition or the implication of the contract law norm, therefore the parties can agree on any other applicable condition)
2. Allowing potestative conditions in contracts, as well as potestative obligations.
3. Introducing representations and warranties, a new concept for the Russian civil law, which is common in the rest of the world.
4. Regulating indemnity agreements.
5. Legalizing withdrawal fees.
6. Legal regulation of good faith deposits.
7. Different approaches to the lowering of liquidated damages for commercial and non-commercial borrowers.
8. Introducing Irrevocable Power of Attorney for special cases and types of business.
9. Introducing the practice of Escrow.
10. Introducing collateral management in the interests of several parties.
11. Contractual subordination of lenders for the same borrower.
12. Enabling the parties of a service contract to limit the possibility of unilateral withdrawal.