The 2015 reform of the Russian law of obligations (changes to the relevant section of the Civil Code of the Russian Federation (hereinafter – the Civil Code) came into force on June 1, 2015) may have a major impact on bankruptcy proceedings. The implementation of the new legal doctrines has only just begun, yet the first cases to reach the Supreme Court of the Russian Federation have already revealed major issues.

The Civil Code incorporated legal innovations relevant to entrepreneurs, such as payment for repudiation of obligations (p.3 art. 310 of the Civil Code) and restitution for damages incurred due to commencement of the circumstances stipulated under the contract (art. 406.1 of the Civil Code). The latter is an adaptation of the indemnity doctrine of the English law and is entirely novel for Russian law. Both payments can be made anticipatory by the parties, and can be secured by chosen means of securing an obligation – for instance, by a security deposit, another new addition to the Civil Code.

In the event of a debtor’s bankruptcy, the other party with a claim to a secured payment will attempt to satisfy its claim at the expense of the means of security. Not only does this create issues related to preferential treatment of some creditors’ claims over others, but also in relation to determining the amount due. For instance, do the parties to the agreement have the right to set the payment for repudiation of obligations to a very high arbitrary amount, or should this amount have an upper cap? In the event of a debtor’s bankruptcy, is it permissible to withdraw a significant amount as a contractual payment to one creditor if it has no economic basis (for instance, if it is unrelated to actual damages of the creditor and recompense thereof)?

Since Russian case law involving the implementation of art. 406.1 of the Civil Code is yet to be formed, the issues can currently be considered in the context of payments under p.3 art. 310 of the Civil Code. Payment for repudiation of obligations had existed under different names prior to the inclusion of the relevant provisions into the Civil Code, the Code merely formalized the established practice. One of the cases involving a “pre-reform” agreement was reviewed in June by the Chamber for commercial disputes of the Supreme Court of the Russian Federation (hereinafter – the Chamber). Known as “X5 Real Estate” Case”, it is a hot-button case extensively discussed by the Russian legal community.

The case concerns a long-term lease agreement with a 15-year term that was made in 2011. The parties to the agreement specified a nonrefundable advance payment to be retained in the event of a unilateral repudiation of the agreement by the lessee. The payment was calculated as the fixed part of the lease payment for the entire lease term (15 years) and was paid by the lessee immediately following the execution of the agreement. Four years later, the lessee surrendered the lease of the property and the lessor did not refund the advance payment, resulting in a judicial dispute. The courts of the lower jurisdictions ruled that the lessor was not entitled to retain the advance payment in the amount significantly greater than the term of occupancy of the leased property by the lessee, since it constituted unjust enrichment. In doing so, the courts created confusion as to the legal status of the relationship.

The Chamber unambiguously determined that, in this case, the nonrefundable advance payment retained by the lessor constituted payment for repudiation of the agreement. The Chamber conceptually agreed with the validity of the payment, but remitted the case for a new investigation of the amount due.  The Chamber stated that the court needs to determine this amount using the principle of good faith as the relevant criterion. Consequently, the Chamber allowed for judicial reduction of the contractually stipulated payment for repudiation of the agreement on the basis of the principle of good faith. This decision caused substantial backlash from the adherents of the freedom-of-contract doctrine.   

Even though the “X5 Real Estate” case is not related to bankruptcy (the lessee repudiated the agreement for reasons other than bankruptcy), the Supreme Court’s stance on the matter is of primary relevance to the bankruptcy field. In the event of a debtor’s bankruptcy, he inevitably repudiates his contractual obligations. Paragraph 3 of article 310 of the Civil Code does not contain any special provisions related to the reason for repudiation. Therefore, the contract can stipulate a payment not only for voluntary, but also for involuntary repudiation of the obligations. Therefore, the Civil Code does not prevent the parties from establishing a payment for repudiation of the agreement in the event of debtor’s bankruptcy. In the event of bankruptcy of the lessee, the lessor would likewise retain the advance payment instead of returning it to the bankruptcy estate. That would limit the ability of other creditors of the debtor to satisfy their respective claims.

It will be difficult to find grounds for forced recovery of the repudiation payment that had been received by the creditor in advance into the bankruptcy estate.  Under certain conditions, one could attempt to challenge the repudiation payment clause as such on the grounds that it constitutes a suspicious transaction or a “transaction with an unfair preference” (as defined by Chapter III.1 of the Law on Bankruptcy). For instance, such a challenge would make sense if an agreement with a repudiation payment clause was made between affiliated parties, so that the creditor colluding with the debtor would be able to use the contractual payment to obtain a significant amount at the expense of the “external” creditors of the debtor.

However, large-scale challenges of such provisions pose a threat. They may result in an almost total prohibition against payments for repudiation of the agreement in the event of the debtor’s bankruptcy. The provisions that enable the parties to determine this payment and similar payments under the contract will be rendered considerably meaningless. The current topic of discussion among the legal community is the limit on the freedom of contract and the ability of the parties to determine the amount to be paid, but complete invalidation of repudiation payment clauses will leave no place whatsoever for the freedom of contract.

By limiting the freedom-of-contract doctrine through the principle of good faith the Chamber establishes a delicate approach to the issues that may foreseeably arise in the field of bankruptcy.  A payment under p. 3 art. 310 of the Civil Code is permissible, but its amount needs to be economically justified and comply with the principle of good faith. The Plenum of Supreme Court of the Russian Federation had provided a prior interpretation of article 406.1 of the Civil Code, noting that restitution of losses is allowed only under the circumstances that are related to the primary obligation of the parties, rather than any circumstances agreed upon by the parties.

In view of the above, the Supreme Court of the Russian Federation is trying to establish a framework for new types of payments that can have their grounds and amount freely determined by the parties to a contract. Even though the Civil Code does not provide express limitations, unlimited discretion of the parties may cause problems and incentivize abuse in bankruptcy cases.