New Law on "Amendments to the Law on Insolvency (Bankruptcy) and Articles 17 and 223 of the Arbitrage Procedural Code with respect to establishment of special rules for bankruptcy of developers attracting money from participants in construction" was adopted on July 12, 2011 (the "Amendments"). Most of the Amendments were introduced as a special chapter No. 7 named "Bankruptcy of Developers" into the Federal law on Insolvency (Bankruptcy) No. 127-FZ as of 26 October 2002 (as amended) (the "Bankruptcy Law").

The Amendments are aimed at regulating bankruptcy proceedings against property developers engaged in construction of residential apartment blocks. In particular, the Amendments govern bankruptcy-related claims in connection with pre-sales of residential premises under construction, regardless of the various guises under which such pre-sales may hide. The Amendments directly affect the practice of application of the notorious Federal Law No. 214-FZ "On participation in construction of residential apartment blocks and other properties" (the "Participatory Construction Law"), the use of which becomes more and more wide-spread on the market, if only insofar as mass-market residential construction is concerned.

The Amendments came into force on August 15, 2011 save for one paragraph amending Article 4.1 of the Bankruptcy Law which will come into force on January 1, 2012.

Who benefits – inclusive rights of claim

The Amendments expressly extend the new bankruptcy regime to claims under any types of arrangements which in effect envisage pre-sale of apartments under construction to individuals, despite their ostensible nullity, though participants under proper and registrable participatory construction agreements (“PCA”) still have the additional benefits available to them under the Participatory Construction Law, e.g. statutory pledge over the property.

Who is answerable – novel definition of property developer

Unlike the common legal use of the term, the new bankruptcy regime introduces the notion of "developer" regardless of whether they have properly documented property rights to the land plot underlying development or the apartment block. The "developer" is merely defined as obligor under any participants' claims, either to hand over the property, or of financial nature.

Where to litigate – participants hold sway

Bankruptcy cases are currently tried at the debtor's location, whereas under the Amendments the court may move proceedings to a court at the location of the land plot underlying the development, the apartment block, or even the place of residence of the majority of participants in the best interest of the participants. Thus, a foreign or Moscow-based bank lending to a Moscow-based developer may hypothetically end up involved in lengthy and costly proceedings anywhere else where that developer happens to run into trouble building apartment blocks.

Measures to combat asset stripping

In order to safeguard the participant's interests the court trying the bankruptcy case may order interim relief in the form of prohibiting the landlord to lease out or otherwise dispose the land plot under development to any persons other than the developer and prohibiting registration of such agreements.

Creditors' claims rank differently

The new rules on claims' ranking did not affect the general principle of the Bankruptcy Law which calls for on-going operating costs and secured claims (including claims made by participants and other parties, e.g. banks) to be satisfied without regard to the usual priority of creditors' claims. Secured claims are satisfied out of the proceeds of a sale of the mortgaged property, but the Amendments introduce specific rules regarding the distribution of the proceeds, favouring the participants rather more than before. Besides, all participants' claims under PCAs are automatically secured by mortgage whereas claims of participants under other types of pre-sale arrangements, as well as claims of banks financing the construction, are not automatically secured unless there is a contractual mortgage arrangements in place.

Pre-sold apartments can be taken out of the estate

The Amendments allow to take the contested development out of the bankruptcy estate and hand the apartments over to the participants in the following way:

  1. Unfinished apartment block – transfer of the developer's rights to the unfinished apartment block and the underlying land plot to a cooperative (e.g., housing association) formed by the participants as a way of satisfaction of the participant's claims. The cooperative must then finish the construction of the apartment block and transfer relevant apartments to the participants; or
  1. finished and commissioned apartment block – direct transfer of ownership to the apartments to the participants.

Both options to take the pre-sold apartments out of the estate for the benefit of the participants are not absolute and are possible only if certain quantitative conditions are met. In any case, if the overall value of the participants' claims exceeds the value of the apartments or entitlements handed over to the participants as described earlier, the outstanding part of the participants' claims is then satisfied in accordance with the general provisions of the Bankruptcy Law. So if the participants wish to claim statutory damages under the Participatory Construction Law after the apartments have been handed over to them, these claims will no longer be privileged.

Step in rights

In order to make the transfer of assets to the participants possible, the Amendments allow any third party to step into the shoes of the developer and provide the funds sufficient to pay off the current operating payments and claims of the first and second priority. After these prior-ranking claims are satisfied, the third party becomes a third-ranking creditor pari passu with the individual participants, thus being put in a more favourable position compared with other creditors, including unsecured banks.