On August 20 2013, the Supreme Arbitrazh (Commercial) Court of the Russian Federation (the “SAC”) issued Resolution of Plenary Session No. 62 “On Certain Matters of Compensation of Losses by Members of a Company’s Governing Bodies” dated 30 July 2013 (the “Resolution”). The Resolution represents a huge initial stride in clarifying the duties of officers and directors of Russian companies and could have a profound positive impact on corporate governance practices of Russian commercial organizations as a result of providing a more coherent roadmap for guiding conduct and pursuing civil relief against officers and directors who act in violation of their fiduciary duties to the companies they serve.

The Standard

Russian law has long provided that officers and directors must act “reasonably” and in the “best interests of the company” and that officers and directors may bear joint personal liability before the company (directly or derivatively) for losses (actual loss and/or lost profits) incurred by the company for “culpable” or “wrongful” actions or inactions. The terms, “culpable” or “wrongful”, however, were not defined under the law nor was the duty to act “reasonably” and in the “best interests of the company” well developed. Notably the burden of proof lay with the party alleging the breach of duty.

Clarity and predictability in fiduciary duty standards applicable to company agents is a fundamental bedrock principal necessary for the development of a robust commercial market. On the one hand, the standards cannot be too restrictive so as to deter businesses from engaging in commercially reasonable risk taking necessary for growth and innovation. On the other hand, they cannot be too lax so as to permit a company’s agents to abuse their positions to the detriment of the company they serve.

To date, the Russian system has done a poor job in balancing these competing interests, favouring an ineffective criminalization of conduct while at the same time failing to provide a workable civil mechanism to protect investors from self-dealing agents. The Resolution is a welcome step forward in providing a more functional civil framework to guide officers seeking to grow the businesses of company they serve while providing investors with a civil tool to police the conduct of their agents. Only time will tell if these principles will be applied in an even handed way necessary for the effective functioning of the markets and advancing Russia’s goal of becoming a respected financial center, but the initial application of the Resolution is promising.

Directors and Officers Subject to the Standard

The Resolution clarifies that the following categories of persons may be held liable to a company for losses incurred as a result of bad faith actions: (a) CEOs: general directors, management companies, managers, directors of the unitary enterprise; (b) members of the collegial executive bodies: members of the board of directors (supervisory boards); (c) individuals who used to be the members of the company’s governing bodies; (d) liquidators (members of the liquidation committee); and (e) external managers and receivers.

Bad Faith Conduct of Directors and Officers

The Resolution clearly provides bad faith may be found were a director or officer:

  1. Acted despite a existence of a conflict of interest;
  2. Conceded information or knowingly provided to the shareholders incorrect information on a transaction entered into by him;
  3. Entered into a transaction without having obtained the requisite approvals as required by law or the company’s charter;
  4. Knew or should have known that the counterparty is “knowingly unable to perform its obligations”; and
  5. Knew or should have known that the transaction was unfavorable for the company (e.g. sale of assets at a substantially undervalued price).

Unreasonable Conduct

The Resolution further emphasized that the director may be held liable for “unreasonable actions” even though he acts in good faith. According to the Resolution unreasonable conduct includes:

  1. Failing to perform adequate due diligence;
  2. Taking action notwithstanding known relevant information; and
  3. Failing to comply with the company’s internal procedures (e.g. sign off by accounting, legal, etc.).

Compliance with Law

The SAC made clear that a reasonable director shall procure that the company fulfills its public law obligations.1 Therefore, if a company breaches its legal obligations due to director’s bad faith and/or unreasonable actions or omissions which result in losses by the company, such losses may be recovered from the director. The company will be restricted from indemnifying director for his actions/omissions which result from the company’s breach of its public law obligations.2

Choice of Counterparties and Employee Hiring

The SAC has also indicated that a director is required to put in place an effective management structure with the company. Thus more emphasis is given to director’s default liability for selection of candidates, choice of counterparties in contracts and the company’s agents unless otherwise is provided by company’s internal documents and policies. The SAC has provided that it is possible to claim from director losses incurred by the company as a result of the director’s bad faith or unreasonable conduct (omission) in the performance of his duties with respect to choosing/overseeing:

  • The company’s agents;
  • Counterparties in private contracts (a counterparty turned out to be dishonest);
  • The company’s employees (a director has hired an incompetent employee whose actions caused losses to the company).

Three Key Procedural Aspects of the Resolution

  1. Burden Shifting. The SAC adopted a key procedural change that fundamentally modifies the playing field by providing that a court may shift the burden of proof on the director to prove why his conduct did not violate the standard of proof under certain circumstances, such as if the director refuses to provide any explanations or provides insufficient explanations for his actions typically when proof has been presented that the director acted in the face of a conflict of interest.
  2. Proof of Damages. In the past the courts dismissed claims in most cases on the basis that the claimant could not prove the exact amount of loss. Under the Resolution the SAC demonstrated a more nuanced and sophisticated approach to damages analysis. Moreover, the SAC clearly demonstrated an approach that focused on substance over form, which has not typically been the approach in past decisions.
  3. Expansion of Standing to Pursue Losses. The Resolution provides that a new shareholder or participant3 has the right to claim damages from director who has acted in bad faith or unreasonably prior to the shareholders acquisition of shares. This decision is a little curious because while the duty runs to the company the new shareholder arguably was in a position to conduct due diligence and price the risk (assuming it was not fraudulently concealed). The limitations period for such claims is three years starting from the day when a new shareholder/participant’s predecessor learned or should have learned about the director’s misconduct. When the predecessor (the claimant) is the company itself the limitation period starts upon the day when the company could realistically have learned of the director’s misconduct. Based on the foregoing, one would expect that officers and directors will increasingly insist on waivers of potential claims in connection with exit transactions.

Relief from Civil Liability to Pay Damages

The Resolution provides for a number of grounds any of which allows a director to be relieved from an obligation to pay damages:

  • If a director has not gone beyond ordinary business risk;
  • If a director proves that an unfavorable transaction:
    • was part of a series of transactions, as a result of which the company was expected to obtain gain; or
    • was made with the intention to avoid more adverse consequences for the company;
  • If the losses have been duly recovered by means of another remedy (e.g. losses have been recovered from the wrongdoer (e.g. employee or counterparty) and other). The SAC has indicated that allowing claim for damages does not depend on whether a transaction, which caused damages, was or was not invalidated.

The SAC expressly provided that approval of director’s actions by the company’s management board or shareholders does not by itself release him from liability for bad faith and/or unreasonable conduct, which results in losses for the company. In addition the SAC has established that members of the management board may be relieved from civil liability if they voted against a decision that resulted in losses for the company or while acting in good faith, did not participate in the voting.

Case Study Shortly after issuance of the Resolution, the Moscow Commercial Court awarded damages in the amount of RUB7.5 million (US$240,000) to Mindshare Interactions LLC (“Mindshare”) against its ex-director Mr. Ashmanov based on losses which were found to have arisen from his bad faith conduct.4

Mr. Ashmanov in his capacity as general director of Mindshare concluded an advertisement services agreement in 2009, with a so-called “one day company”. The court found that Mindshare paid fees to LLC Vektor for the period of two years, but no services were provided by LLC Vektor to Mindshare. The amount of fees paid to the sham company amounted to RUB7.5 million by 2010. In 2011 Mr. Ashmanov was removed from his position as general director.

In 2012 the Moscow Tax Inspectorate conducted a tax audit of Mindshare and thereafter claimed that Mindshare violated tax laws, in particular, it failed to pay the full amount of income tax payable by it as a result of understating its tax basis by declaring that RUB7.5 million were expenses under services agreement. Because the Moscow Tax Inspectorate concluded that the services agreement was sham and that no services were rendered to Mindshare, it could not validly reduce its taxable obligations on the basis of the advertising contract.

In response to the audit and tax claims the new director of Mindshare investigated the violation and on behalf of the company filed a lawsuit against Mr. Ashmanov. Mindshare claimed damages from Mr. Ashmanov in the amount of RUB7.5 million. The limitation period was found to have been observed – Mindshare was found to have become aware of the damages incurred by the company in 2012 when the new director received the Moscow Tax Inspectorate’s audit report.

The court awarded damages in full in favor of Mindshare specifically referring to the positions of the Resolution. The court found that Mr. Ashmanov acted unreasonably and in bad faith in that:

  • He knew or should have known that he entered into a transaction with a “one day” and that a transaction was unfavorable for the company;
  • He failed to perform a due diligence on the counterparty or to confirm that services were actually provided under the contract;
  • He completed an agreement without the observance of the internal procedures adopted within the company; and
  • His actions led to Mindshare being held liable for a tax offence.

Upon request of the court Mr. Ashmanov failed to provide countervailing evidence that he acted in good faith or and reasonably.