Arbitral awards are often used to obtain an undue control in bankruptcy cases. In simple terms, affiliated companies use the mechanism described below to enable a creditor to unlawfully gain the status of a first applicant in subsequent bankruptcy proceedings, and thus, control the proceedings:
– A dubious obligation to pay a large amount (e.g. for delivery of goods, provision of services or a loan, etc.) is created between Company A, which is being prepared for bankruptcy, and its affiliated Company B.
– Company B files a claim against Company A with an arbitral tribunal and, in the absence of objections from Company A, predictably wins the case (to this end, various “pocket” arbitral tribunals were often used in the past, but they have now been abolished).
– Company B then applies to a state commercial court with a request to issue a writ of execution in respect of Company A.
– The state court, which does not have the right to revise arbitral awards on their merits, limits itself to formal verification of the case and issues a writ of execution (again, in the absence of objections from Company A).
– Company B then has the opportunity to begin bankruptcy proceedings against Company A at any suitable moment, having overtaken all third-party creditors.
Similar schemes to establish control in bankruptcy of affiliated companies (with some possible variations) have been actively used by unscrupulous business people in recent years. This has resulted in an absurd situation, where the positive features of arbitration proceedings (confidentiality, efficiency and inadmissibility of a substantive review of arbitral awards by state courts) are essentially misused to the detriment of the interests of third-party creditors in bankruptcy proceedings.
The Ruling is particularly significant for law enforcement practice as, for the first time, the Supreme Court has, in its practice, indicated that the concept of public order can be applied in bankruptcy disputes to protect the interests of good faith creditors.
Also, in this Ruling, a new standard of proof has been established to protect a good faith creditor in bankruptcy proceedings initiated by a bad faith creditor based on an arbitral award.
The facts of the case
Two affiliated companies, the Lender and the Borrower, entered into a loan agreement. The Lender then filed a claim with the competent arbitral tribunal, accusing the Borrower of failing to repay a part of the loan. The Borrower admitted the debt and stated that it had no money to pay. The arbitral tribunal foreseeably ruled in favour of the Lender.
The Lender subsequently obtained a writ of execution to enforce the arbitral award, but did not take any steps to recover the debt.
The Lender only applied to the competent court for a bankruptcy petition when the bank that had previously issued a loan to the Borrower (the “Bank”) published a notice of its intention to petition for a declaration of bankruptcy.
The Bank interpreted the coordinated actions of the Borrower and the Lender as an abuse of rights aimed at obtaining unjustified privileges in the bankruptcy proceedings and appealed the court’s decision to issue the writ of execution of the arbitral award on cassation, referring to a violation of the public order of the Russian Federation. In the opinion of the Bank, the actual purpose of the Lender’s recourse to the court was to create obstacles for the Bank and other independent creditors of the Borrower in the exercise of their rights as a creditor and first applicant in the bankruptcy proceedings.
Although there were no disproving arguments on the part of the Borrower and the Creditor, the court of cassation instance left the ruling on the issue of the writ of execution of the arbitral award unchanged, which served as the basis for the Bank’s appeal to the Supreme Court.
The position of the Supreme Court
The Supreme Court took into account the following circumstances that raised suspicion as to the bad faith behind the actions of the bankrupt Borrower and the Creditor:
– Despite the fact that there was an allegedly outstanding debt that served as the basis for the Creditor’s application to the arbitral tribunal, during the period under review, significant payments were made under other agreements between the Lender and the Borrower.
– In addition, during the period under review, the bankrupt Borrower received large payments from third-party counterparties and also settled material debts with third parties.
– The Creditor applied to the court for the Borrower to be declared bankrupt only after the Bank had published a notice of its intention to petition the court for the same.
– The Borrower and the Lender are affiliated entities and obviously coordinated their actions both in the arbitration and the bankruptcy proceedings.
– Taking into consideration all these circumstances, the actions of the Borrower and the Lender preceding the bankruptcy can neither be seen as reasonable nor commercially justified.
Based on these circumstances, the Supreme Court agreed with the Bank’s argument on the abuse of rights by the Borrower and the Lender. The abuse was characterised in (i) the use of legal entities contrary to the actual purpose of their creation and (ii) the unfair use of an arbitral tribunal as a means of resolving a dispute to undertake unlawful actions in bankruptcy proceedings. These abuses led to the adoption of unlawful rulings in the bankruptcy proceedings that violated the rights of the independent creditors, which in turn, contradict the public order of the Russian Federation.
The Supreme Court also noted that the creditors are objectively limited in their ability to prove the groundlessness of the other applicant’s claim, if this claim is based on an arbitral award. Therefore, it is sufficient for creditors in such a situation to present prima facie evidence, i.e. evidence that, at first glance, confirms the materiality of doubts about the existence of the debt. The Supreme Court rightly observed that it should not be difficult for a lender, who insists on the existence of the debt which was acknowledged by an arbitral tribunal, to refute these doubts since it is precisely the creditor who possesses all the evidence relating to its claims against the insolvent debtor.
The Supreme Court emphasised that when examining the cases on the issue of writs of execution of arbitral awards, the courts must check that the participants in the bankruptcy proceedings acted in good faith to an extent that is necessary to ensure the protection of the rights of third parties who did not participate in the proceedings, but whose rights and obligations form the subject matter of a court ruling and, in particular, of good faith creditors of the debtor.
We expect that the Supreme Court’s approach on how to assess arbitral awards in bankruptcy proceedings will help in the ongoing fight against bad faith creditors.
We also believe that the explanations given in the Ruling on the fair application of the prima facie principle when allocating the burden of proof can also be used in other cases involving affiliated entities and the possibility of coordinating the actions of such entities. This principle could, in particular, be used by the shareholders of a legal entity to challenge the company’s transactions (such claims are often referred to as “Russian torpedoes”).
* In Russian