Since Federal Law No. 214-FZ “On Participation in Participatory Share Construction of Multi-Apartment Residential Buildings and Other Real Estate and on the Amendment of Certain Legislative Acts of the Russian Federation,” dated December 30, 2004 (as amended) (the “Participatory Share Construction Law”), was adopted more than six years ago, it has been subject to frequent and severe scrutiny and discussion between the business community, legal practitioners, and scholars. This is due to the ambiguous language of the Participatory Share Construction Law, which was aimed at protecting individuals and legal entities that invest in the construction of property, but did not clearly set out the rules and mechanisms for imposing liability on unscrupulous developers. The need to revise the Participatory Share Construction Law increased following the negative fall out from the credit crunch, when most developers were facing a lack of funds, and many were thus unable to complete all of the projects that they had contractually agreed to for investors (both legal entities and individuals).

As a result, in the summer of 2010, a new set of amendments to certain Russian laws regulating participatory share construction (Rus. долевое строительство) was finally adopted by the State Duma of the Russian Federation (the “RF”). These amendments were introduced by Federal Law No. 119-FZ “On the Amendments to the Federal Law, ‘On the State Registration of Immovable Property Rights and Transactions Therewith,’ and Several Legislative Acts of the Russian Federation,” dated June 17, 2010 (the “Amendment Law”), which, in addition to affecting the Participatory Share Construction Law, also affects several codes and other legal acts.1 With certain exceptions, the new amendments came into legal force on June 21, 2010.

For the sake of convenience, and since the amendments are very distinct in their nature, this article focuses only on the principal amendments to the Participatory Share Construction Law (the “SCL Amendments”), in particular those affecting the entire construction and development industry (including construction companies, developers and investors).

As mentioned above, the Participatory Share Construction Law was adopted with the aim of protecting the interests of investors and incentivizing developers and construction companies to operate in the Russian market in strict compliance with Russian construction and other laws. However, a variety of practical problems have been associated with the implementation of the Participatory Share Construction Law in the past, including those outlined below.

Abuse of Individuals’ Rights by Unscrupulous Developers Using Non-Statutory Construction Schemes

The operational requirements set forth by the Share Construction Law have always been inconvenient and burdensome for developers, imposing numerous additional requirements of both a financial and a technical nature. Of numerous requirements, the most unpopular and rarely observed in practice was the requirement to use so-called participatory share construction agreements when raising funds from individuals. In particular, developers were reluctant to use these participatory share construction agreements because: (a) the Participatory Share Construction Law established mandatory provisions to be incorporated into the agreements; (b) the agreements required registration with the state authorities; (c) having been registered with the state authorities, these agreements created an encumbrance over the developers’ real estate and entitled an individual to trigger a foreclosure procedure over the real estate upon the occurrence of certain events; and (d) the use of participatory share construction agreements increased the level of liability on developers (compared with all other agreements previously used for the same purpose). The wording of the Participatory Share Construction Law was also imprecise, and certain provisions were quite ambiguous when taken together (i.e., it was possible to dispute its mandatory application to construction).

Therefore, up until the recent amendments, developers had been very creative in avoiding the use of participatory share construction agreements in their operations and, thus the application of the mandatory provisions of the Participatory Share Construction Law. In practice, these avoidance schemes frequently included: (a) the execution of promissory note sale and purchase agreements; (b) the execution of preliminary sale and purchase agreements over premises; or (c) a combination of the above. These schemes were not strictly prohibited under the then-applicable legislation. Despite the fact that the use of these alternative schemes was common practice in Russia, and that this gave rise to frequent controversy, including disputes and public protests (by investors who had been deceived), the case law finding these schemes illegal (void) was very limited. Therefore, until recently, those individual investors who invested in property caught up in these schemes were not protected, and this often resulted in abuses of their rights by developers.

This situation, however, is likely to change substantially with the adoption of the SCL Amendments. Starting from June 21, 2010, developers are only authorized to raise funds from individuals on the basis of participatory share construction agreements. Thus, all other schemes (such as the execution of preliminary agreements, the sale of promissory notes, or a combination of the above) are forbidden by statute (except for the issue of residential construction bonds (certificates) and the raising of funds by cooperative societies (special legal entities), directly permitted by the Participatory Share Construction Law). The mandatory requirements imposed by the Participatory Share Construction Law can no longer be avoided by developers, and the position of individual investors has consequently been significantly improved in comparison to past practice.

This express statutory ban on the use of alternative schemes to raise finance from individuals for construction is considered to be the principal benefit from the SCL Amendments. It appears that the SCL Amendments have had the desired effect and many of the well-known and reputable developers have initiated the process of converting their operations from alternative schemes to those specifically permitted by the Participatory Share Construction Law.

The Need to Protect the Interests of Bona Fide Developers Facing the Consequences of the Credit Crunch

The downside of the mandatory imposition of participatory share construction schemes described in paragraph (1) above, however, is that the restriction on using any alternative schemes has significantly limited the ability of developers to raise external financing at the earlier stages of construction. Based on the Participatory Share Construction Law, participatory share construction agreements can only be executed (and financing obtained) after a construction permit has been received. Unfortunately, the state authorities responsible for the issuance of construction permits and for monitoring the compliance of construction operations with Russian law remain extremely bureaucratic and are known to create artificial obstacles; in practice it often takes a significant amount of time to receive all of the necessary documents and permits. Given that the time available for the construction of real estate is usually limited by a relevant obligation to a governmental or municipal authority (e.g., by a term of validity in an investment contract, or by the inclusion of a condition to complete construction within a certain period of time in a resolution of a local authority granting rights over a land plot), the requirement that financing can only be acquired after the relevant construction permit is received significantly limits the time available for the construction of a real estate object, especially when external financing from individuals is used. In other words, should an investment contract state that the construction of a residential house must be accomplished within four years, and a bona fide developer is going to finance construction from external sources only (i.e., from individuals), this four year period will in practice be significantly shortened by: (a) the time required for the issuance of a construction permit; and (b) the time required to raise enough funds from individuals to begin construction.

To balance the interests of developers and investors and to motivate developers to convert their operations into schemes which are fully compliant with the Participatory Share Construction Law, a new tax benefit initiative has been introduced into law. In particular, the Tax Code has been amended to provide that VAT is no longer applied to services rendered by developers under participatory share construction agreements (except industrial constructions). Developers will be able to apply this tax relief in the fourth quarter of 2010. It is expected that this statutory development will positively affect the financial standing of developers.

The Need to Set Forth Clear Rules and Mechanisms for Imposing Liability on Developers

As discussed above, the past application of the Participatory Share Construction Law failed to prevent numerous violations of individuals’ rights by unfair developers which was the main impetus for the further imposition of liability on developers. In addition, the procedure for imposing liability was not sufficiently clear and straightforward.

It appears that the SCL Amendments seek to resolve these problems by imposing the following sanctions for the violation of the Participatory Share Construction Law (and in particular for the improper raising of funds from individuals (including through using other types of schemes)):

  • Damages. An individual may claim: (a) the immediate refund of all amounts paid to the developer; (b) the payment of interest at double the statutory rate calculated in accordance with Article 395 of the RF Civil Code; and (c) the payment of damages (in addition to the payment of interest at double the statutory rate calculated in accordance with Article 395 of the RF Civil Code on such amounts).  
  • Administrative Fines. A developer (a legal entity) may be held administratively liable in an amount varying from RUB 500,000 to RUB 1,000,000 (approximately EUR 12,755 to EUR 25,510). The officers of the developer may be held administratively liable in an amount varying from RUB 20,000 to RUB 50,000 (approximately EUR 510 - EUR 1,275). Please note that administrative liability may be imposed on the developer (and its officers) for each violation of the Participatory Share Construction Law separately so that raising funds from each individual in violation of the Participatory Share Construction Law will trigger administrative liability in each case on the developer.  
  • Challenge in Courts. The SCL Amendments expressly provide that a transaction entered into in violation of the Participatory Share Construction Law may be challenged in court (but note that such a transaction is not deemed to be void from the moment when it was made, but only from the moment when the court overturns it). The statute of limitations for bringing such a challenge is one year from the date when an interested person learned or should have learned of the violation. This claim can only be brought by the individual who entered into the relevant transaction.

Application of the SCL Amendments in Practice

At the time of drafting the SCL Amendments, there was discussion about making the law retroactive to apply to those agreements which were already in effect. However, it appears the SCL Amendments do not include such a provision. Nevertheless, since the SCL Amendments are relatively new and there appear to be no reported cases interpreting the new law, it is possible that courts could attempt to apply them retroactively. Thus, it is advisable (where possible and applicable) for developers to proceed with converting agreements entered into under other schemes into participatory share construction agreements to ensure compliance with these recent Russian law changes and to avoid any negative implications in this respect in the future.