Effective as of 1 June 2015, Russian Civil Code will undergo significant changes insofar as provisions relating to contract law are concerned (“Amendments”). The Amendments are far-reaching in scope and cover such areas as contractual representations, new rules for collateral and contractual undertakings, pre-contractual liability, etc. Essentially, the Amendments are intended to specifically recognize concepts which are widely used in practice in an international context or approaches recently developed by Russian courts.
The main aim of this reform is to make Russian contract law rules more flexible and business-friendly and, thus, avoid an unnecessary recourse to foreign law.
In general, the Amendments are a significant step towards creating a healthy business environment. At the same time, the Amendments represent a compromise between different scholars and practitioners and unhelpfully leave a number of open-ended questions. We expect that many legal issues will be resolved in the course of their application by Russian courts although such application may reveal even more issues.
Where all of the parties are Russian or a major Russian counterparty insists on using Russian law as governing, then it should generally be possible to build in customary contractual protections using new Russian legal concepts subject to certain reservations. In particular, we recommend that parties detail various possible outcomes, e.g. the rules for calculation of damages or contractual interest, rather than allow the court to interpret statutory provisions or parties' intent. Parties may also wish to mitigate the risk of unsatisfactory or unintended application of new Russian legal concepts by entering into a foreign law deed of indemnity in addition to their Russian law arrangements. Such instrument could potentially be a helpful tool to the extent parties have significant assets abroad in order to satisfy claims.
Until the new rules are tested in Russian court practice, parties may wish to continue using foreign law in the context of major cross-border M&A transactions, especially at the offshore level. Foreign law would typically come hand-in-and with international arbitration as disputes resolution venue. At the same time, the risk remains that disputes relating to share purchase agreements and shareholders agreements in respect of a Russian company (ie at the onshore level) may be viewed as "corporate disputes" which are within the exclusive competence of Russian state courts.
Below you will find a short summary of most notable changes in the context of M&A transactions and our critical look at issues which still remain to be clarified, remedied or tested in courts.
Representations about facts
- For the first time, Russian law will see a concept of contractual representations. The concept is widely used in international M&A transactions. In many respects, it is similar to an English law concept of representations and warranties. Essentially, a party which gave false representations to the other side, will have to compensate such other side for the damages incurred or pay an agreed contractual interest. The right to such compensation is not affected by the fact that the underlying contract may be invalid or unconcluded.
- Where a representation is material, a non-breaching party may additionally rescind the contract. Alternatively, where the contract was made through fraud or material error, then the non-breaching party may seek to unwind the transaction in court.
- It should be possible for a party to give representations relating to both itself (e.g. title and capacity representations) and a third party (e.g. business representations relating to the target).
- Parties should be mindful about other statutory remedies available to them, eg in case of bad title, lack of capacity to contract, unidentified encumbrances. The conditions for such other remedies to be available may differ from those relating to representation claims (eg it is possible to challenge a transaction for seller's internal corporate limitations to contract only if the other party new about the fact). However, the scope of such other remedies may be wider, for instance in case of bad title to shares purchaser can claim not only rescind a contract and claim damages but also claim a diminution of the purchase price.
- Russian law does not currently have such distinct legal concept. In the absence of such concept, parties would either seek to apply foreign law or use some other Russian legal concepts with a view to achieve a similar result. Most commonly in Russian law M&A, representations would come under the label of specific requirements relating to the quality of the goods. In this case target's good standing would be typically viewed as a quality requirement relating to target's shares. In another common pattern, a breach of certain statements about the shares being offered would be expressly treated in the context of a material error or fraud. However, a major inconvenience was inconsistent court practice which made the practical use of these concepts risky.
Issues Still Remain
- Actual knowledge. New rules are silent as to whether the actual knowledge of the purchaser about the problem would exempt the seller from liability. However, arguably, such exemption could be inferred from a general civil law principle that parties must act in good faith. For the safety sake, we recommend specifying this exemption in the contract.
- Time period for making claims. Russian law imposes a general limitations period of 3 years. The starting point for this period in M&A context would be when the breaching party refused to compensate the other side or failed to do so within a reasonable time following a notice to this effect from such other side. An overall cap of 10 years applies. Any contractual provision which purports to set out a different time period or a different method of its calculation risks being held void. It is not entirely clear from the law (although not expressly prohibited), whether parties may set out a period for making claims for breach of representations without changing the statute of limitations (which would be a common practice under English law). For example, under Russian law a period for making quality claims may be agreed contractually. We hope that the courts will apply the general principle of contractual freedom and endorse such contractual stipulation of time period s for making representation-based claims. Anyawya, , parties may, as a mitigant, stipulate that the contractual interest amount will significantly vary depending on when the claim is made.
- Lack of established court practice. Until a uniform court practice evolves, we expect that parties would exercise reasonable caution when using new Russian legal concepts in cross-border M&As.
- When the Amendments take effect, it will become possible to provide for compensation of losses which one party may suffer in case of a particular event occurring and outside the other party's fault. The concept of indemnity is widely used in an international M&A context, e.g. sellers indemnifying purchasers in case particular risks materialize which were revealed in the course of the due diligence. The contract containing an indemnity clause must specify the amount of indemnification or method for its calculation. A court may not reduce the amount unless the addressee of the indemnity has wilfully inflated such amount.
- Currently, indemnities are not expressly recognised under Russian law. There are at least two reasons why the use of indemnities is difficult and risks being held unenforceable as a matter of Russian law: (i) it is problematic to agree on a compensation of losses not arising as a result of breach (unless the obligation is an insurance or other specific contact) and (ii) it is problematic to structure conditional undertakings in an enforceable way where conditions are within a party's control (e.g. indemnity for failure to obtain the financing or enter into a material contract).
Issues Still Remain
- Indemnity from parent. A literal interpretation of the law suggests that an indemnity can be provided only by a party to the underlying obligation. Thus, it is not entirely clear whether a parent company or any other third party (not being otherwise part of the transaction documents) can give an indemnity, which is common place in foreign law practice. We expect that further court practice should clarify this point.
- Indemnity for losses incurred by the target. The law suggests that the trigger for indemnity claims can be an event affecting not only a party to the underlying obligation but a third party, e.g. target company in an M&A context. At the same time, a difficulty is whether and under which conditions losses suffered by the target would translate into losses at the purchaser's end. Unless the situation is tested in court, it may be recommendable to stipulate this expressly in the indemnity undertaking.
As an alternative, parties could make the target company an indemnified person under an SPA (in addition to an SPA party). If this approach is upheld by courts, then the target company would be entitled to claim compensation under the indemnity (which is a common practice in English law governed indemnity provisions). However, for the reason described above (ie a restrictive statutory wording as to who can give indemnity to whom) this approach is risky and remains to be tested in court practice.
- Limitations period. Similarly to representations, the statutory limitations period for indemnity claims is 3 years and cannot be amended contractually.
- The Amendments introduced two distinct legal concepts, namely (i) option to enter into an agreement; and (ii) option agreement.
- Under the option to enter into an agreement the grantor, by means of an irrevocable offer, gives to the other side a right to enter into a contract on the terms set out in the agreement. Under the option agreement, one party to the contract is entitled to claim performance of a contractual obligation by the other party. In case the performance has not been asked for within the agreed time period, the option contract terminates.
- It is rather unusual that options of both types were included into the Amendments, since essentially they are aimed at regulating the same relationships. The main difference between them is that under an option the main contract is only made when the offer is accepted. Under the option agreement one party is entitled to force the other party to perform an existing contractual obligation.
- Russian law does not specifically recognise options. Court practice has been inconsistent: there were rulings where courts invalidated options as conditional agreements (which should not generally be subject to satisfaction by the parties) or as preliminary agreements which do not comply with statutory requirements as to the form (according to a prevailing court practice, preliminary agreements in respect of participatory interest in an LLC should be notarised).
- Parties would either seek to apply foreign law or use some ill-suited Russian legal concepts with a view to achieve a similar result (eg Russian-law irrevocable offer or preliminary agreement). However, these alternatives did not offer the same level of comfort as proper options.
- Against the general trend mentioned above, a legal concept otherwise known in the industry as a Russian law call option has been in existence since 2009 in the context of M&A transactions involving Russian LLCs. Notably, conclusion of an SPA can expressly be made conditional upon certain circumstances occurring and the purchaser could force the seller to transfer the title through court, the court ruling being the legal ground for the title registration. This option does not require notarisation.
Issues Still Remain
- Which of the two models to choose? Generally, the two concepts could be used interchangeably. At the same time, certain issues may appear in the context of transactions with participatory interests in LLCs which require notarisation in order to be effective. Pursuant to the Amendments, the option to enter into a contract (first model) must be made in the same form as the main contract. There are no similar rules for option agreements (second model). It would be helpful if the court practice would clarify that the subject-matter of the option (first model) is not the actual transfer but the grant of the right to enter into the SPA. In a limited court practice, a similar approach was used in the context of preliminary contracts. In this case, notarisation would not be required for grant of the option but would still be required for the actual transfer of title. However, until and unless such practice develops, we expect that parties would prefer the option agreement (second model) if they wish to avoid the notarisation requirement at the time when the option is granted. As a general remark, the two sets of rules for the two models are not identical and in order to avoid unintended issues, it is recommendable that the parties should refer to a particular model when drafting options.
- Remedies available to purchaser. It is not entirely clear whether the non-breaching party would be able to seek transfer of share/participatory interest or only claim damages. Arguably, specific performance is possible (eg under the Russian law call option model for LLCs) so long as the assets have not been transferred to a bona fide third party. In the context of share/participatory interest transfers, purchaser could additionally seek an irrevocable power of attorney authorising it to sign and submit an instrument of transfer on seller's behalf. For the safety sake, we would recommend specifying the remedies directly in the contract.
- Remedies available to the seller. It is not entirely clear which remedies the seller can use in case the purchaser refuses to buy. Arguably, in addition to damages (mainly abstract), the seller could seek to force the purchaser to accept the transfer of shares/participatory interest. At the same time, the outcome is not guaranteed (unlike in the Russian law call option for LLCs) in the absence of a provision saying that the court ruling in this case would be the legal basis for the title transfer. We recommend specifying applicable remedies directly in the contract.
Other significant amendments
"Conditions precedent" (CPs) allowed
- Russian courts often invalidated contracts containing CPs which were subject to being satisfied by parties (e.g. obtaining financing, execution of another document, etc.). Currently, the whole transaction can be conditional only upon circumstances which are beyond parties' control. The Amendments do not change this rule, however they will expressly allow "conditional performance of obligations" under a contract with conditions being subject to satisfaction by the parties.
- Hopefully, the existing concept of "condition transaction" will not hamper the use of CPs. However, for the safety sake, we recommend that CPs are drafted as conditions to performance of obligations rather than conditions to the contract coming into force in order to avoid the above-mentioned risk.
Independent guarantee vs bank guarantee
- The concept of independent guarantee replaced the bank guarantee. Guarantor will not have to be a credit organisations but can be any other commercial legal entity. It is a useful amendment since bank guarantees have been an expensive instrument.
- The independent guarantee will be capable of being adjusted, if such option is properly built in. Absence of express provisions to this effect has typically cause practical issues where the underlying obligation was subject to change over time.
- The Amendments now helpfully expressly stipulate beneficiary's duty to compensate the guarantor or principal for the damages in case of improper claim.
New rules relating to suretyship
- The requirements relating to suretyship agreements are going to be expressly liberalised. For instance, the Amendments now directly authorise suretyship of non-monetary and future obligations. The obligation secured by suretyship may be identified by a simple reference to the contract. Parties in b2b contracts may secure all obligations between them up to a directly stipulated maximum amount.
- Unlike now, the death/liquidation of the debtor will not terminate the suretyship. The surety may agree to be liable in case of future amendments to the principal obligation and in case of transfer of debt to a new debtor, provided that the limits of debt and list of new debtors are specified in the agreement.
Concept of pre-contractual liability introduced
- Under the new concept, the parties must act in good faith in the course of their negotiations (and not only in performance of their contractual obligations). As a general rule, the party acting in bad faith must compensate the damages to the other party. Typical examples of bad faith would include: provision of incorrect or incomplete material information or unexpected and unreasoned termination of negotiations. Unlike the position in some continental law jurisdictions such as Germany or Switzerland, damages may cover loss of an opportunity to contract with a third party and legal/advisory fees. We recommend that parties' carefully consider possible implications of their behaviour at the pre-contractual stage.