October 13, 2015
In a recent decision of 9 October the Supreme Court of the Russian Federation extended safeguards for bankruptcy creditors against unfounded claims based on arbitral awards.
The abuse of arbitration for the purposes of creating fake grounds for claims to get the most out of the debtor’s bankruptcy has long been a problem in Russia. For instance, a debtor and its affiliate can make a sham (fabricated) loan agreement, containing an arbitration clause.
Based on such agreement an ad hoc arbitral tribunal renders its award in favor of the affiliated creditor. This award later becomes a perfect ground for the inclusion of the bad faith creditor into the register of creditors and satisfaction of its claims on par with other creditors. Alternatively, the whole arbitral proceedings may constitute a sham.
Several procedural and practical problems arise in this regard.
First of all, most of the creditors in bankruptcy proceedings are not parties to arbitration. Therefore, they do not participate in enforcement proceedings and cannot present their objections. However, the Supreme Commercial Court clarified in 2012 that creditors have a right to appeal against the award enforcement decision outside bankruptcy proceedings.
Secondly, even having such a right, creditors face substantial practical difficulties disputing the validity of arbitral awards. This results from the confidentiality of arbitral proceedings and the absence of a centralized authority (especially in ad hoc arbitration).
Furthermore, a case may pose a procedural dilemma whether the enforcement should happen as a part or or outside of bankruptcy proceedings. As a matter of Russian insolvency law, all creditors’ claims shall be filed in insolvency proceedings, as soon as such proceedings are launched. As the Supreme Commercial Court clarified in 2011, claims based on arbitral awards are not an exception.
The Supreme Court case discussed here began in 2012, when GARTIC LIMITED, Hong Kong (“GARTIC“) applied for the recognition and enforcement of an ad hoc arbitral award in the amount of RUB 1.4 bln (appr. EUR 19 mln) (the “Award“), rendered against Russian JSC Murmansk Multiservice Networks (“MMN“). On 10 December 2012 the court granted this application. Soon after this, MMN went into bankruptcy and GARTIC became its registered creditor.
One of MMN’s other creditors – Manufacturing company Eltekhmontazh LLC (“Eltekh“, “appellant“) – considered that the Award was a sham and that in reality no arbitration proceedings took place. It filed an appeal against the decision for recognition and enforcement, but failed. The Federal Commercial Court for Moscow region reasoned that Eltekh did not provide sufficient proof that the Award was a sham. This decision was however reversed by the Supreme Commercial Court in its resolution dated 13 May 2014, which emphasised the practical difficulty for a non-party to arbitration to adduce evidence to dispute an arbitral award. The court held that it was enough for a creditor to submit prima facie evidence confirming reasonableness of its doubts. The case went for a retrial.
However, in the new trial Eltekh did not succeed. The court stated that Eltekh had abused its procedural rights, as it had not appeared before the court and had not provided sound arguments to support its falsification claims. According to the court, the text of the Award proved that arbitral proceedings did indeed take place. As a result, the court granted enforcement. The Commercial Court for Moscow region supported these findings. Eltekh appealed to the Supreme Court, which once again remanded the case for ade novo review.
The Supreme Court emphasised that is is a matter of public policy to protect rights of third parties in relations with an insolvent debtor. Therefore, the courts shall consider interests of third parties (ie creditors) when deciding on an application for recognition and enforcement of a foreign arbitral award.
The court confirmed that as a matter of law, since insolvency proceedings begin, all monetary claims that arose previously shall be filed in such proceedings. If a party files an application for recognition and enforcement before the insolvency procedure is open, it is up to such a party to choose whether to continue outside bankruptcy or re-file in bankruptcy proceedings. However, in any case, enforcement of an arbitral award would be precluded by special insolvency rules (collective satisfaction of claims).
As regards the issue of evidence and the burden of proof, the court highlighted that it was not for a party disputing the award to prove its false character, but for the party to arbitration to present facts and evidence to dispel any doubts that arbitration was genuine. According to the court, any other interpretation would impose on a creditor a burden of proving a negative fact.
In the case at hand, it was for GARTIC (as a party to arbitration) to demonstrate the validity of arbitration, not for Eltekh to disprove it. Besides, the Supreme Court noted that the courts failed to assess whether enforcement of an arbitral award outside bankruptcy would lead to unjustified (preferential) satisfaction of a claim and violation of other creditors’ rights.
The Supreme Court of the Russian Federation continues its fight against abuses of arbitration, one of the underlying drivers of the modern arbitration reform in Russia. This time the court made the life of good faith creditors in Russian insolvency proceedings easier. When disputing arbitral awards (enforcement decisions), they do not need to prove the invalidity of an arbitral award. It is enough for them to express reasonable doubts that arbitration really took place (sham arbitration). In such a case, it would be for the interested party (a party to arbitration) to provide evidence to the contrary.
As regards procedural matters, the claimant who files an application for recognition and enforcement before the initiation of insolvency proceedings has two options: to continue outside bankruptcy or re-file its claim in insolvency. In either case, separate execution of an award would be impossible due to limitations imposed by Russian bankruptcy law. This makes extra-insolvency filings for recognition and enforcement of arbitral awards less appealing and provides additional safeguards to creditors.
This publication was originally drafted by Ilya Kokorin for CIS Arbitration Forum, a collaborative project of scholars and practitioners focusing on dispute resolution involving the former Soviet Union countries.