How to avoid subsidiary liability

By Ekaterina Kalinkina, Head of Intercomp Branch in Ryazan

Organizations may, in some cases, recover debts from their founders or managers. It would seem that such unpleasant event occurs only in case of bankruptcy so top managers in stable and prosperous companies have nothing to worry about. However, this is not always that cut and dried.

Ekaterina Kalinkina
Head of Intercomp Branch in Ryazan

It is no coincidence that the concept of “debtor controlling person” has been broadly used in current laws so as to increase the number of those who may be exposed and “put on the line”. There has also been lately a clear tendency to expand the boundaries of subsidiary liability as evidenced by Federal Law No. 488-FZ dated December 28, 2016 which came into force on June 28, 2017 (further “Law No. 488-FZ”).

Forewarned is forearmed. Ekaterina Kalinkina, Head of Intercomp Branch in Ryazan, has grappled with the intricacies of Russian laws to present some preventive measures and possible consequences of subsidiary liability.

What is subsidiary liability?

Subsidiary liability is an additional financial liability provided for certain persons in a company in the amount of the company’s debt owed to creditors and authorized bodies, including tax authorities. Such liability may be provided not only for company managers, founders, but also for anyone who can conclude transactions on behalf of the company, give instructions or determine the company’s actions on any ground (Article 53.1(3) Russian Civil Code, Article 61.10(1) Bankruptcy Law) regardless of whether or not there are any formal and legal indications of affiliation.

In what cases do subsidiary liability arise?

People with significant control may be brought to subsidiary liability and pay the debts owed by their company in the following cases (Federal Law N 12-FZ On Insolvency (bankruptcy) dated October 26, 2002):

  • Full repayment of creditors’ claims is not possible due to the actions/inactions of such controlling persons (Article 61.11 Federal Law No. 127-FZ);
  • Non-submission (late submission) of bankruptcy petition (Article 61.12 Federal Law No. 127-FZ);
  • Violation of bankruptcy law (Article 61.13 Federal Law No. 127-FZ).

What is the timeframe for subsidiary liability?

Subsidiary liability may be invoked within three years of the date on which a creditor became aware of the grounds for such liability but no later than three years from the date of bankruptcy recognition. The exclusion of a company debtor from the State Register of Legal entities is not a reason to forget debts.

How to avoid subsidiary liability?

Amendments to the law have made it even more difficult to prove innocence and avoid subsidiary liability. To minimize the risk of such liability, company managers, founders and other controlling persons need to apply preventive measures such as, for example:

  • Avoid selling their organization’s assets at an understated price;
  • Not knowingly concluding unprofitable transactions with related parties, fictitious transactions;
  • In case of loss of financial, accounting documents, taking measures to restore them;
  • Exercising due diligence when selecting counterparties;
  • Monitoring overdue debts on a regular basis and take timely measures to eliminate them (repay or contest them).

What to do in case of subsidiary liability?

It should be noted that under current laws controlling persons are presumed guilty so to avoid being brought to subsidiary liability a debtor’s controlling persons must prove that:

  1. losses were incurred through no fault of their own;
  2. decisions were made reasonably and in good faith;
  3. there are no causal links between the actions (inactions) of controlling persons and the losses suffered by their company, or prove their wish and will to prevent greater damage.

As a rule, controlling persons may provide as documentary evidence reports from auditors, independent valuation organizations, documents supporting business transactions, etc.

For example, a manager can prove that insolvency signs are not yet evidence of the company’s objective bankruptcy and that he attempted to tackle the circumstances within a reasonable time period and did whatever was required to that end. A financial recovery plan approved, for example, by an extraordinary general meeting of the company’s shareholders could be submitted as documentary evidence of such attempt.

The Supreme Court Plenum issued in December 2017 very detailed clarifications of how the amendments introduced by Law No. 488-FZ to the regulation of liability in case of a legal entity’s bankruptcy should be applied in practice (Supreme Court Ruling No. 53 On Certain Issues Related to the Liability of a Debtor’s Controlling Persons upon Bankruptcy dated December 21, 2017). These clarifications also describe situations where controlling persons are not subject to subsidiary liability. For example, if the actions (inactions) of a debtor’s controlling person resulting in negative consequences for the debtor were within the limits of usual business risk and were not intended to violate the creditor’s rights and legal interests, then the controlling person will not, in such case, be subject to subsidiary liability.