It has been a year since Decree No. 54 of the Plenum of the Supreme Commercial Court of the Russian Federation (the “SCC”) “On certain issues of resolving disputes arising from agreements relating to properties to be built or purchased in the future” (the “Decree”) was adopted.
What has the year brought to investors? What trends are noteworthy and what should one do to protect his interests? We will try to share with you certain observations and conclusions.
Means of protection which do not protect
Following the adoption of the Decree, a persistent court practice was formed by which investors have been denied ownership rights if a property is under construction or it actually has been completed and put in operation, but the developer has not registered ownership (for example, Ruling No. VAS-5553/12 of the SCC, dated 16 May 2012; Ruling No. VAS-2834/12 of the SCC, dated 28 March 2012).
This approach is because the majority of investment agreements have been recognised as purchase and sale agreements in relation to future real estate. The logic is simple: legally, real estate does not exist until it is registered, so it is not possible to perform a purchase and sale agreement. What could be done? The agreement could be terminated and/or losses could be reimbursed. An investor (buyer) could compel the seller (developer) to transfer the property only once the developer has commissioned the property and registered its ownership to it.
The right to receive at least an incomplete property has practically been replaced with the right to be reimbursed for losses. The latter option is far from always being to the liking of investors. It is not only that the amount of losses must be proven, but a favourable court decision is not always enforceable. Indeed, by the time of enforcing the decision, the developer may already have neither money nor assets.
What could be done in this situation? The obvious option would be to change the conditions of the investment agreement so it would be impossible to recognise it as a purchase and sale agreement. What could replace a purchase and sale agreement?
“Not simple” partnership
The Decree itself mentions a simple partnership agreement (a joint venture agreement). This type of agreement is attractive in that the share in the property under construction arises as early as during construction. If any problems arise, a partner may count on retaining its share even if construction has not been completed.
However, there are some drawbacks. In order to register ownership of an investment, a partner must have rights to the land, for example, be a party to the land lease agreement. This is stated directly in the Decree. Does an investor need this? An investor’s goal is to profit from its investment. Participating in land relationships at the construction stage as a rule does not meet this criterion.
Moreover, in becoming a partner, an investor becomes one of the participants in the joint venture, risks losses, and is responsible for the actions of the partnership along with the other participants.
Taking into consideration the above, we recommend being very cautious when entering into a simple partnership agreement, thoroughly weighing all pros and cons.
It would seem that the solution could be found by applying Federal Law No. 214-FZ “On Participating in a Shared Construction of a Multi-Apartment Buildings and other Properties…”, dated 30 December 2004 (the “Law”).
The Law mainly applies to regular citizens who invest their savings in the construction of residential property for their own use. However, the Law could also apply to relationships between legal entities when constructing commercial real estate. Although such a practice is not widespread among developers.
This is understandable. The Law regulates matters of liability in detail, with the aim of protecting the investors, and requiring developers to disclose information publicly, including their financial position. Few developers will agree to work under such conditions, as they are not expressly required by the Law to do so when building commercial real estate.
However, this Law also does not eliminate all problems. Indeed, commercial courts considering claims for recognition of ownership rights, do not differentiate between this and purchase and sale agreements. A good example would be case А40-150035/10-60-941 that was recently upheld by the SCC. According to the court, a reference to the Law On Participating in a Shared Construction does not grant an investor the ownership right (including a shared ownership) to the property under construction in which he invests.
Hence, based on current commercial court practice, before construction has been completed and all the necessary documents have been submitted to the registration authorities, an investor may file similar claims with a commercial court as in the case of a purchase and sale agreement.
The courts of general jurisdiction also often refuse to recognise ownership rights to specific premises, but are more inclined to recognise a specific share in the joint shared ownership of the property under construction (for example, the Moscow City Court Ruling dated 24 April 2012 re case No. 33-9321). These courts review cases involving private citizens, so their jurisdiction does not extend to the economic disputes of legal entities.
Nevertheless, there are enough advantages of entering into agreements for shared construction for investors to use this type of agreement in practice. For example, the state registration of an agreement protects an investor from the double selling of the same property, and the pledge arising by operation of law, even if it isn’t a cure-all, in any case substantially strengthens the position of an investor.
Alternatives for large investors
An important question is how can one protect his investment in this situation? One can use various means to secure obligations, such as pledge, penalties, and/or bank guarantees. Legislation does not prohibit a party to set up its own type of security. Insurance may also be used. However, insurance against entrepreneurial risks in Russia is more often the exception than the rule. Far from all companies offer this type of insurance.
Large investors that fully or substantially finance construction, have more influence on a developer. Taking into consideration their strong negotiating position, they could use corporate mechanisms to take control over the developer if the latter fails to comply with the terms of the investment agreement. Moreover, these mechanisms do not necessarily have to be governed by Russian law. Indeed, control over a Russian legal entity could also be obtained by acquiring the shares in the foreign parent company.
In these instances, it is important to bring the proposed mechanisms in line with the ways of financing the Russian developer in order to take advantage of both foreign law and Russian legislation if a dispute does arise.
Interesting questions arise at the intersection of civil and tax law. A year after the Decree was adopted, it is possible to state that the relationships of the parties in civil law and tax disputes are qualified in an essentially different way.
A prime example of this is the decree of the Presidium of the SCC of 26 June 2012 re case А38-1216/2011. In discussing this case, attention was paid particularly to the necessity of applying tax legislation similar to an agency agreement. In our view the agency nature of such relationship is well demonstrated by collective VAT invoices which technically could be considered agent’s VAT invoices for funds of the principal used to purchase goods and services in the interest of the latter.
The court in this case confirmed that the existing tax treatment remains unchanged, and when re-issuing the VAT invoices issued by the contractors, the developer does not expose itself to liability to pay VAT on these invoices to the budget, given that it has not sold real estate property.
When resolving this case, the court’s reference to sub-paragraph 4 of paragraph 3 of Article 39 of the Tax Code (the “Tax Code”) has significant meaning. In so doing, the court expressly stated that the transfer of property under an investment agreement cannot be considered as a sale for tax purposes.
Some experts are of the same opinion. However, the Ministry of Finance has not made reference to this Article in its official clarifications. Now even if the relationship of the parties to the agreement is considered to be one of purchase and sale for civil law purposes, this operation is not considered a sale for tax purposes. This at least is what clearly follows from analysing Article 39.3.4. of the Tax Code. We hope that future court practice will confirm this conclusion.
As a result, in tax disputes the court still suggests treating the transfer of real estate property under an investment agreement, only on the basis of tax law, using the concepts of “sale” and “investment activity”. In civil law disputes, the courts chose to recognise an investment agreement as a purchase and sale agreement, applying all of the respective consequences of which we have spoken above.
We will keep you updated as to the latest trends in the practice of resolving disputes in respect of investment agreements, because “he who is forewarned is forearmed”.