With the credit crunch impacting the Russian banking sector and Russian banks facing their gravest crisis since 1998 (as evidenced by Bank Globex freezing deposits), it is in our view timely to revisit the regulations affecting the insolvency of Russian credit organisations.

The principal source of regulation relating to insolvency of credit organisations in Russia is Federal Law No. 127-FZ “On insolvency (the bankruptcy)“ dated 26 October 2002 (the “Insolvency Law”) and, as to particular aspects applicable to credit organisations, Federal Law No. 40-FZ “On insolvency (bankruptcy) of credit organisations” dated 25 February 1999 (the “Credit Organisations’ Insolvency Law”) and Federal Law No. 395-1 “On Banks and Banking Activity” dated 2 December 1990 (the “Banking Law”).

Credit organisations include banks and non-banking credit organisations. Both types of credit organisations may performbanking operations only after the receipt of (and before the withdrawal of) a licence granted by the Central Bank of the Russian Federation (the “CBR”). As the insolvency regulation of banks and non-banking organisations is similar under Russian law, we will refer to both of these entities using a generic term“credit organisations”.

Insolvency procedures can be initiated in relation to credit organisations andmay be divided into two broad categories: 

  • insolvency procedures, aimed at prevention of insolvency – “insolvency prevention procedures”; and 
  • insolvency procedures, aimed at the fair distribution of assets of a credit organisation – “liquidation procedures”. 
  • Insolvency prevention procedures generally do not deal with the distribution of assets of a credit organisation to its creditors. However, such preventivemeasures are discussed within an insolvency context, as their introduction entails considerable intervention and supervision fromthe banks’ regulatory authority.

In this letter we consider first the insolvency prevention procedures, then liquidation procedures and finally outline certain substantive issues which have to be considered in the context of insolvency of credit organisations.

Insolvency prevention procedures 

Insolvency prevention procedures were introduced in 1999 due to the crisis in Russia. Eventsmoved so fast that the Russian state could not prevent the insolvency ofmajor banks such as Inkombank and a systemic failure in the Russian banking system. One aimof this legislation, which slowed down the eventual insolvency of SBS Agro, is to prevent creditors fromliquidating a Russian bank without the consent of the Russian Central Bank.

Where the CBR identifies specific circumstances of a financial or compliance nature which are not serious enough to trigger the revocation of a banking licence but whichmight, if not remedied, cause further deterioration of the financial condition of the credit organisation, the CBR may require that the credit organisation undertakes insolvency preventionmeasures.

The general principle for the application of the insolvency prevention procedures (except for certain powers enjoyed by an interimadministration) is that the credit organisation is permitted to continue its general course of business under closer surveillance by the CBR. Insolvency prevention procedures are triggered by a deterioration of mandatory financial ratios, which are applicable to credit organisations. However,many of the trigger events may well be caused by amarket downturn rather than by the fundamental problems specific to a credit organisation.

The Credit Organisations Insolvency Law envisages three measures for insolvency prevention:

  • financial rehabilitation; 
  • reorganisation; and 
  • interimadministration

Financial rehabilitation

The CBR may impose interimadministration if a credit organisation: 

  • fails to: (i) satisfy themonetary claims of its creditors; or (ii) makemandatory payments within three days after the due date on a repeated basis within a sixmonth period and such failure arises due to a lack of funds on its correspondent accounts; 
  • fails (even once) to: (i) satisfy themonetary claims of its creditors; or (ii)makemandatory paymentsmore than three days of the due date and such failure arises due to the lack of funds at its correspondence accounts; 
  • permits a reduction in its bank capital by more than 20% fromthemaximumlevel of bank capital achieved over the preceding 12months with a simultaneous breach of one of the CBRmandatory bank ratios; 
  • breaches capital adequacy ratio (H1) (which sets the correlation between capital of a credit organisation and its risk-weighted assets); 
  • breaches bymore than 10%in any givenmonth, the current liquidity ratio (H3) (which sets the ratio between the short-termassets of a credit organisation (recoverable in less than onemonth) and its short-term liabilities (claimable within onemonth); or 
  • permits (according to itsmonthly accounts) a reduction in capital below its charter capital as determined by the constitutional instruments of the organisation (provided this trigger shall not apply if such reduction occurs, within the first two years after a license is granted to a credit organisation by the CBR).

The relevant credit organisation is required to take measures which fall within the financial rehabilitation procedures. The CBRmay demand that suchmeasures are taken. Thesemeasures are aimed at improving the financial soundness of a credit organisation either by means of: (i) financial assistance to be rendered by the shareholders of the credit organisation; or (ii) reducing its expenditures.

The financial rehabilitationmay take the formof: 

  • a shareholder granting loans to a credit organisation on “below-market” terms; 
  • shareholders’ providing guarantees for the financial obligations of the credit organisation; 
  • raising the share capital of the credit organisation; 
  • the sale of non-profitable assets; 
  • restructuring of assets; 
  • cutting operational expenditures; or 
  • taking othermeasures to ensure compliance with relevant CBR ratios.

The shareholders decide on themeasures to take to restore the financial condition of the credit organisation. Shareholders are also obliged to take steps to prevent the insolvency of the credit organisation.

Upon the occurrence of any event that triggers the financial rehabilitation procedure, the credit organisation is obligated to notify the CBR of: 

  • when it intends to hold a general shareholders’meetings or ameeting of the board of directors (and the CBR is entitled to send an observer to participate in either meeting); and 
  • entering into certain qualifying transactions (for example, transactions entered into with affiliated entities or exceeding 1%of its balance sheet value).

If the financial rehabilitation procedures are instigated by the CBR, then in addition to restrictions set out above, the credit organisationmay notmake any distributions to its shareholders.

The above restrictions shall cease to apply if the grounds which triggered the introduction of the rehabilitation proceedings cease to exist.Where financial rehabilitation procedures have been initiated by the CBR, the relaxation of restrictions will also require a separate confirmation issued by the CBR.

Reorganisation of a credit organisation

Reorganisation of a credit organisationmay be carried out at the request of its shareholders (with a view to restoring its financial condition) or on demand by the CBR. Such demandmay bemade if the conditions for the introduction of an interimadministration are satisfied. The reorganisation may be carried out either in the formofmerger (sliyanie) or accession (prisoyedinenie).

Appointment of interimadministration

The CBR may impose an interimadministration if: (i) the conditions for the imposition of financial rehabilitation apply; or (ii) the credit organisation:

  • fails (even once) to: (i) satisfy themonetary claims of its creditors; or (ii)makemandatory paymentsmore than seven days after the due date and such failure arises due to the lack of funds at its correspondent accounts; 
  • permits a reduction in its bank capital bymore than 30% fromthemaximumlevel of bank capital achieved over the preceding 12months with a simultaneous breach of one of the CBRmandatory bank ratios;
  • breaches bymore than 20%in any givenmonth, the current liquidity ratio (H3); or 
  • does not comply with a demand of the CBR to replace any of itsmanagement bodies; or 
  • commits acts, whichmay entail the revocation of the banking licence (the closed list of such acts are set out in Article 20 of the Banking Law and are set out in Appendix 1 to this note).

During the interimadministration procedure, the powers of themanagement of the credit organisationmay be restricted or suspended. In the latter case an administrator takes control of the credit organisation and undertakes procedures aimed at repaying the organisation’s debts and restoring its financial condition. Interimadministration is imposed by a decision of the CBR for a period not exceeding sixmonths.

In addition, the CBR willmay impose also interim administration upon it revoking of the licence of the credit organisation. In this case the interimadministration is introduced for the period following the revocation of the licence until an arbitrazh court passes a decision on the liquidation of the credit organisation. The interim administration takes over themanagement of the credit organisation with a view to preserving its assets for future liquidation.

The revocation of the licence of a credit organisation triggers the followingmajor consequences: 

  • allmonetary obligations of the credit organisation, which were incurred prior to licence being revoked become due and payable; 
  • no default interest or other penalties can accrue on the debts of the credit organisation; 
  • levying execution against the assets of the credit organisation is, generally, suspended; 
  • the credit organisationmay not: (i) performany transactions in relation to its property; (ii) pay any mandatory charges; (iii) or terminate any of itsmonetary obligations bymeans of set-off; and 
  • the credit organisationmay not dispose of any funds standing to its correspondent accounts.

The above restrictions do not apply to the discharge of the “current liabilities” of the credit organisation (for example, the paymentsmade to ensure the day-to-day operation of the credit organisation or to cover insolvency related expenses).

Liquidation procedures

Liquidation procedures in relation to a credit organisation can be divided into two broad categories: (i) liquidation of a solvent credit organisation; and (ii) liquidation of an insolvent credit organisation.

Liquidation of a solvent credit organisation

To the extent that the liquidated credit organisation can discharge all of its debts, no insolvency proceedings will be initiated. A credit organisationmay be voluntarily liquidated by a decision of its shareholders or by a decision of an arbitrazh court upon application of the CBR.

The procedure for the liquidation of a solvent credit organisation is, generally, similar to the insolvency procedure, which is discussed below.

However, should in any of the above scenarios the credit organisation be not able to satisfy the claims of all of its creditors, the credit organisation will need to undergo insolvency proceedings.

Liquidation of an insolvent credit organisation Insolvency proceedings in relation to a credit organisation can be commenced upon the petition of: 

  • a creditor (including, individuals which have deposit or account agreement claims against a credit organisation); 
  • the credit organisation itself; 
  • the Federal Tax Service; 
  • local authorities; or 
  • the CBR.

Such an applicationmust be filed with an arbitrazh court at the place of incorporation of the credit organisation.

A creditor or the Federal Tax Servicemay file an insolvency petition with an arbitrazh court if: 

  • the CBR has revoked the licence of the credit organisation; 
  • the indebtedness of the credit organisation is equal to or exceeds 1,000 times theminimummonthly wage (approximately, US$4,000); 
  • the indebtedness is outstanding formore than 14 days after it became due and payable or (following the revocation of a licence) the credit organisation’s assets are judged to be insufficient to discharge its liabilities; and 
  • the indebtedness is confirmed by:

(A) a judgment which has entered into legal force; or

(B) a decision of the relevant tax or customs authorities (levying execution on the property of the credit organisation).

The arbitrazh court has tomake a ruling on whether to commence the liquidation of the insolvent organisation within two months of the date when the insolvency application petition is lodged with the court.

The introduction of liquidation procedure triggers the following consequences:

  • the liquidator replaces themanagement of the credit organisation and has the authority to deal with the assets of the credit organisation to satisfy creditors’ claims; 
  • any restrictions (as set out above in section 2.16 above) ensuing fromthe revocation of the licence continue to apply; 
  • information on the financial standing of the credit organisation is no longer protected by the commercial secrecy regime; 
  • except for a limited number of cases, all creditors’ claims must be filed in accordance with the liquidation procedure; and 
  • enforcement proceedings in respect of existing claims are suspended and freezing orders over the assets of the credit organisation are lifted.

The liquidator of a credit organisation is an officer licensed by the CBR or in the case of a credit organisation which is also a deposit taking institution, the Deposit Insurance Agency (which is an entity responsible for themandatory insurance of individual bank accounts and deposits).

The liquidator’s duties include preparation of liquidation balance sheets, distribution of assets to creditors and filing a report of the results of the liquidation with the arbitrazh court. The court, upon receipt of such report, then passes a resolution on the completion of liquidation and approves the liquidator’s report. The period of time for the liquidation of the insolvent credit organisationmay not exceed one year, with a possible extension of a further sixmonths.

Specific insolvency issues

Priority of claims

The Insolvency Law provides for the ranking of creditors’ claims in the liquidation of the credit organisation. There are certain provisions, which favour the interests of individuals and which significantly prejudice the position of the corporate creditors.

The general rules for the ranking of creditors in insolvency are set out in the Insolvency Law and provide for the following priority rules:

  • repayment of current liabilities (which, generally, include dayto- day operational expenses, insolvency costs and payment obligations arising after the commencement of the insolvency proceedings) take priority over all other claims. 
  • The ranking of the other claims is as follows:

(A) first priority – personal injury claims;

(B) second priority – salaries, severance and copyright payments; and

(C) third priority – all other claims.

The Credit Organisations’ Insolvency Law expands the category of the claims that constitute the first priority group to include:

  • claims of individuals (except for those who are entrepreneurs who opened bank accounts in connection with their business activity) who have claims against the credit organisation under bank deposit or bank account agreements (except for lost revenue and penalties claims, which fall in the third priority); and 
  • the claims of the Deposit Insurance Agency and the CBR under contracts of bank deposit and bank account assigned to themas a result of payments to the relevant depositors and account holders.

Furthermore, under the general insolvency regime, claims that fall within the third level of priority which are secured by a pledge (mortgage) are satisfied in priority to unsecured claims ranking in the first or second priority categories (except for claims of first and second priorities arising prior to the creation of the pledge). In contrast, the Credit Organisations’ Insolvency Law sets out that the first and second priority claimants shall take precedence over the claims of the secured creditor.Given the considerable expansion of the first priority group, this rule devalues the use of pledge (mortgage) as a securitymechanismin relation to credit organisations, but this reflects a policy decision on the part of the Russian government to protect bank depositors who had lost out significantly during the 1990’s.

Invalidity of transactions

In addition to the grounds for the invalidation of transactions, which are set out in the Insolvency Law and which apply to all entities (including credit organisations) (for example, invalidation of “preferential treatment” or “connected parties” transactions).

In addition, the Credit Organisations’ Insolvency Law sets out that a transaction entered into by a credit organisation within a period of three years before the appointment of an interimadministrationmay be invalidated at the request of the administrator, the liquidator or the creditor(s) if the terms of such transaction are “materially worse” than the terms of analogous transactions. The legal consequence of the invalidation of the transaction as being preferential or

off-market” is, generally, bilateral restitution – that is the parties to the transaction will be obliged to return to each other everything received in connection with such transaction.

Appendix 1

Grounds for licence revocation

The CBR is obliged to revoke a banking licence if: 

  • H1 ratio falls below 2%; 
  • the capital of a credit organisation fall below theminimum charter requirement set on the date of its incorporation (except within the first two years after incorporation); 
  • a credit organisation fails to bring its charter capital in accordance with the capital requirement during insolvency proceedings initiated by the CBR; 
  • a credit organisation fails tomeet its obligations within 14 days and the amount of the relevant obligations exceed 1,000 times theminimummonthly wage (approximately, US$4,000); or 
  • the value of the assets of a credit organisation falls below minimumcapitalisation requirements (as applying to that credit organisation) for a period of 3 or 12months (depending on the circumstances). TheCBR can revoke a banking licence if a credit organisation: 
  • was incorporated on the basis of false information; 
  • does not undertake banking operations set out in a licence for a period ofmore than 12months fromthe date of licence issuance; 
  • providesmisleading information in its regular reports; 
  • delaysmonthly reports formore than 15 days; 
  • performs banking operations which are not allowed under the relevant licence (including a one-off breach); 
  • repeatedly fails to comply with banking laws over a 12 month period; 
  • repeatedly fails to comply with antimoney laundering legislation over a 12month period; 
  • repeatedly fails to performcourt orders on debiting of funds fromcredit organisation accounts of its clients over a 12 month period; 
  • repeatedly fails to informthe CBR on amendments to its constitutional documents; 
  • is amanager of “mortgage cover” and breaks real estate securities’ regulations; or
  • an interimadministration appointed to prevent insolvency applies to the CBR for revocation.