The “Expert Severo-Zapad” magazine published comments made by lawyer Andrey Mikonin to an article titled “Collective Solon”

26 January 2010

Solon has abated debts, freed those who had been sold into slavery to pay off debts, and abolished loans secured by the pledge of personal liberty. It happened in Athens in the VI century B.C. Not only people but also lands and other property were pledged. Mortgage amnesty became the first reform by Solon in capacity of archon, which cleared the way for other transformations, because economy and society suffocated with debts cannot progress

In Russia in the XXI century fast debt accumulation has created problems at least equal to the above cited, but today these problems are beyond control of a single leader, even a sage. The debt crisis is seated in society lacking mechanisms of cooperation. Cooperation involves consolidated effort, that is why modern reform of debts can only be carried out by joint efforts. Its areas of focus were marked out at the conference “Problemnye dolgi” (“Problematic debts”) held in St-Petersburg at the end of 2009.

Underneath the mat

Any economic problem can be assessed quantatively. Apart from debt problem in Russia. There is more to Russian banks “hiding outstanding debts underneath the mat” (as expert say) than that past-due indebtedness is difficult to evaluate.

Prolongation of problematic loans became the main instrument of “hiding outstanding debts underneath the mat” in 2009. Being aware that a credit shall not be repaid and consequently, financials shall be spoiled, a bank carries pay-back term forward with the idea that the client shall recover from economic shocks and become able to pay, or counting to pawn off problems on other bank managers. To define the situation, Vadim Zhegalov, the Deputy Director General of “Deposit Insurance Agency” (DIA) pointed out that “now intermediate-term loans in banking system has reached 200?300 % of corresponding figures in pre-crisis time”. Such unprecedented growth is indicative of prolongations scale. “As a rule, loans were prolonged for one or two years, added Zhegalov. Is means that in 2010?2011 we, possibly, will resume our discussion of forecasts for the second crisis wave provoked by growth of overdue indebtedness”.

The necessity to assess the deferred issues results in significant discrepancy in the figures quoted by experts. Evgeny Novikov, the VTB Severo-Zapad senior vice president, believes that “the share of potentially problematic debts in the total advances portfolios is 20?25 %. About 10 % of this amount is made of net loss, which shall very likely remain unrepaid”. Dmitry Istyufeev, vice president of BFA bank, made much more radical estimation: the share of more or less problematic loans is about 40 % (of credits issued), not less than 10 % of them will be returned. It means that the fate of another 30% is still quite dark. Should the amount of dead losses remain at 10 % , quoted by Novikov, then the strong banks with solid capitals shall not incur serious losses. Should the rate of 20 % of bad loans be exceeded, Russian financial system shall experience very big problems. “Should the net loss level of 20 % be achieved, a bank shall lose almost all the profit derived from reservation of idle credits, – commented Evgeny Novikov. – This being said, this bank shall be unable to get low-interest credits from the interbank deposit market and the liquidity crisis shall come”.

The likelihood of problematic loan repayment will also depend on professionalism of bank managers and lawyers, and on crisis life cycle, and on whether effective models of relations between creditors and borrowers will be found. The last aspect is crucial.

Over the mat

Dmitry Istyufeev divided all problematic borrowers into four groups. The first group is made of cheaters, who took credits being fully aware that they cannot repay these credits. The second group is made of those who cheated involuntary – at first they intended to pay, but then, by reason of circumstances they decided that it would be easier not to do so. The third group consists of companies willing to repay the credit, but unable to do it. The fourth group consists of those who communicate with bank honestly and offer working solutions, but this group is small.

There is also a fifth category including separate representatives of the three first groups, – borrowers fiercely combated by banks. “Hostilities involve judicial contests, petitions to the procurator's office, criminal prosecutions. Moreover, prosecutions are not aimed at returning funds, since this money is either exported or wantonly spent,” explained Istyufeev. “Criminal prosecutions are used simply to show the business community that should you steal money from the X bank, this bank shall hunt for you all over the spanless Russia, trying to hustle you into the pre-trial detention center.”

Oleg Zherebtsov, the founder of “Lenta” and “Norma” retail chains has further fleshed out this vivid picture of effective relationship, by speaking on behalf of the borrowers. “It is clear that should you litigate with a GAI officer, in 92 % of cases GAI officer shall win. Just because they are better informed of legal issues and have the court on their side,” pointed out Zherebtsov. “Analogically, any businessman sorting out problems with a bank, and God forbid, doing it in court, shall certainly lose. His contractual obligations are many time greater than those of a bank. And the slightest negligence will result in bankruptcy of his business. Security agencies can easily take hostile actions against a company any day of the week, whereas they’ll never intimidate a bank! Because banks have savers to stand for them! Loans exceeding credits by a factor of three or five are normal by Russian standards. Loan rates of 17?20 % at zero inflation are normal too”. “Today relations between creditors and borrowers are unequal. The way things are going, businessmen will avoid any contacts with banks by the end of crisis, apart from setting up a transaction accounts” summed up Zherebtsov.

Boris Fedorov, the director of the Open Business School has rightfully mentioned that the thing is to solve ethical issues in business relationship. “It would be rather ridiculous to speak about ethics in a country showing highest corruption level”, retorted Dmitry Istyufeev. Looking for better ways to solve problems one should choose economically sound relations rather than ethically sound ones. People who pelt their opponents with gold watches at negotiations, yelling: “That is all you get from me”, are behaving in an economically unsound fashion. However, multiple versions of such model are generally practised by both parties.

Subject to the law

In Western countries creditors and borrowers are bound to adhere to mutually satisfactory behaviour by the two types of rules: laws and norms elaborated by branch associations and voluntary observed by businesses.

Ivan Smirnov, the partner of Baker and McKenzie in St.-Petersburg believes that, globally, civilised repayment of debts is provided by the bankruptcy institute supported by rather stringent law. According to Smirnov inevitability of punishment for non repayment is indicatory of good bankruptcy laws. It is such responsibility that forces borrowers to behave ethically. In most Western countries not only official representative of debtors, but also persons who stand behind them (i. e. business owners first of all) are held liable through the bankruptcy procedure.

In 2009 an attempt to make debtors fulfill their obligations was undertaken by domestic legislators, however, this attempt has a rather strange outcome. The new concept of controller introduced into the Russian regulatory system, implies vicarious liability for company’s debts to be imposed on persons who gave mandatory instructions to the firm,– owners, members of liquidation committee, etc. Vicarious liability is also imposed on director general of the enterprise guilty of tampering or losing the accounting documentation. These persons will also be held liable for company’s debts at insufficiency of debtor’s property making up bankrupt estate (i. e. almost in 100 % of cases). New articles refer not only to bankrupts companies, but to enterprises showing signs of bankruptcy as well. These signs, as Ivan Smirnov pointed out, “are formulated in such a fashion that they apply to 90 % of Russian borrowers”. Taking into account this and other details, amendments proved to be “killing” ones, said Smirnov.

Now any person, who shall venture to save a company from crisis situation, shall run unprecedented risks. “they can easily say him: we do not wish to see you here, we wish to see you in court as a vicariously liable person”, – said Sergey Yeliseyev, crisis manager and partner at the management company “М911 +”. According to Ivan Smirnov, no director general but runs the same risks, “because every auditor shall easily prove that your company failed to meet book-keeping regulations”.

Directors of companies listened sadly and promised each other to submit resignation tomorrow. It seems that the task of “creating more reliable and fair legal system aimed at protecting businesses in debt relations», formulated by Oleg Zherebtsov, is not completed. Whereas the task of further reducing the number of people willing to run a business in Russia (if such a task was set) is accomplished.

This case is confirmative of an opinion advanced by Aleksandr Bukhvalov, Professor of Finance at the PricewaterhouseCoopers Graduate School of Management, St. Petersburg State University, that “legislation is an extremely severe instrument” and it would be dangerous to apply it as a fast remedy for economic problems. One may quote an example from the western practice, the Sarbanes–Oxley act, enacted as a reaction to a number of scandal defaults, including those affecting Enron, etc. According to Bukhvalov, “this act prohibits everything, including economically sound principles of corporate governance, and there are continuing discussions regarding level of damage to markets caused by this act”.

This does not necessarily mean that one should resign oneself to bad laws and forbid the State Duma to change them, for fear of even worse developments. On the contrary, the current situation in the debt area dramatically demonstrates the problems coming from poor cooperation in lawmaking. “Experience of work upon amendments to the Bankruptcy Law, and upon the draft law on financial sanation which was not passed and caused public scandals, shows that business community’s failure to sound its needs may result in deplorable consequences,” emphasized Maksim Sterin, the Head of Corporate and M&A Practice at the law company Hannes Snellman in Russia. Then he made an important remark, “Another experience is working upon the draft law “On trade and commerce”, it shows that should even they sound their needs, deplorable consequences may ensue. Nothing can guarantee a quick turn for the better life. However, should we fail to work on amendments to laws, codes of ethics and other rules, the situation shall not improve even by the next crisis. You may depend upon that”. Whereas lawmaking cooperation between creditors, borrowers and the state shall gradually make relationship more effective, however slow the process may be.

Via dialog

Maksim Sterin also mentioned another rules, first of all, the so-called protocols developed by western branch associations – the International Association of Restructuring, Insolvency & Bankruptcy Professionals (INSOL), London market association, etc. These rules are applied by creditors and borrowers to facilitate settlement of controversial situations. Based on a standard protocol, the parties can settle an amicable agreement and profit not at the expense of another, but derive a mutual benefit. Such protocols are like wheels – there is no need to reinvent them and they may be used in Russia as well. Russian business associations (also mentioned by Sterin) should promulgate effective methods of settlement rather then try to reinvent them.

Mikhail Turetsky, the Moscow associate at Baker and McKenzie LLP, has made comments on existing practice of amicable agreements, “Actually, an agreement is made, stipulating that all the parties undertake not to take one-sided actions, not to bring cases before a court, and not to take out assets within several months, necessary to complete negotiations on re-structuring”. The main advantage offered by standard rules to creditors and borrowers, is protection against their own dead-end behaviour. “During crisis, some instincts inherent in creditors and borrowers become more sharp,” continued Turetsky, “large companies start to behave in a way unbecoming even of a small business, for instance, all employees and commodity stocks turn out to belong to some other firm, a fictitious debt arises, or voluntary liquidation begins. On the other hand, banks will send emissaries to the indebted company which will immediately try to seize and sell the assets – no matter what the selling price is. Should a company wind up and should the credit never be returned, it shall matter little.”

Mikhail Turetsky summarized that after the cannibal instincts get blunted, “the atmosphere of cooperation promotes attractive solutions”. It may be a resolution on partial write-down of debt conditional upon regular paying the remaining amount and adopting a more efficient business model, reducing the interest rate on credit, that enables other party to repay it. In a case, exemplified by Turetsky, “During restructurization of debts of the BTA Bank the borrower initially demanded to write off 80 % of the debt. Currently a very interesting comprehensive model is developed and discussed which allows to write off approximately 55 % of debts and to repay the remainder”.

Maksim Sterin agrees that amicable re-structurization is a more beneficial to both parties, than debt repayment through the courts let alone bankruptcy. “In our practice there were cases when the companies expended several million dollars and several years in litigating all over Russia and abroad,” told Sterin, “then they came to the negotiating table and settled their dispute out of court at the cost of two weeks and 70 thousand dollars spent by each party. Both creditor and borrower were very pleased with how they kept their business relationships alive, and wondered why such a genius idea never suggested itself to them before”.

Through intermediary of….

Should the state participate in resolution of debt conflicts? The majority of conference participants replied in the affirmative. ‘In terms of economic logic and civil turnover, the state should act as an intermediary,” believes Maksim Sterin. Mediation activities of the state should proceed in the two main niches, first of them is mediation in making of amicable agreement. Sterin pointed out that, “in many European countries the state represented by state corporations, or regional authorities, or the Ministry of Finance protects bona fide creditors and borrowers from opportunists trying to wreck amicable re-structurization by one-sided actions.” Another niche directly relating to the first one is mediation in implementing sanitation processes.” “Speaking of companies which are economically important at the regional level, the challenge for the state is to work with owners to help them adopt an effective sanitation plan,” believes Yury Voropayev, the director general of MKD holding, “and then to supervise meticulous implementation of this plan and to protect the company during sanitation, which includes protecting it from creditors.”

Is an immediate inference of the state in debt management fraught with voluntarism and corruption? And how! Generally speaking, a manually-operated economy is a bad one. As reasonably observed Vladimir Dzhikovich, the president of the Northwest Banking Association, “Should the state rescue everyone, how shall the market be purged of inefficient businesses? No natural selection via bankruptcies – no development”. But there is the other side of the story: as remarked Voropayev, “given that 90 % of the Russian businesses are inefficient, if you place your stake on bankruptcy procedure, you may immediately leave the country as well.”

“You just cannot find a simple solution in the context of crisis,” Sergey Yeliseyev weighed in on the debate. “That is not to say that a party, including the state, can resolve the situation. And, certainly, it cannot “order” procedures aimed to improve the model of partnership between the state and the private economy. The function of the state is to create platforms for cooperation. One of possible forms is regional sanative structures”. According to Yeliseyev, such structures are meant to pool together efforts of authorities, bankers, owners of the companies, to concentrate financial resources gathered by the said parties, and to use them as an anti-crisis motor”. “A structure generated in this way can rescue a score of businesses in a separate region, by making them undergo sanation procedure, instead of bankruptcy,” concluded Yeliseyev.

The quoted model is raw and even being improved shall remain a stopgap and a short-term fix, though probably, an indispensable one. Long-term remedial measures – legislative development (discussed above), development of the institute of independent intermediaries a key role in successful amicable agreement, improvement of crisis management and management in general. In a word, patching up the holes in the system, which were widened by the problem of debts. As remarked Evgeny Novikov, “civilised relationships between creditors and borrowers will be established in a civilised society. We've got a great deal of work ahead of us to built such society”.

Do not try to make peace through court action

Andrey Mikonin, the lawyer at the company “Vertikal”:

The Russian judiciary system is poorly adapted to support amicable agreements and to protect interests of their participants. Furthermore, should the parties arrive at a conclusion, that there is a need for complex loan restructuring including possible exchange of disputed assets, such transactions cannot be made as simultaneous (package) transactions. In the presence of several concurrent litigations the court shall voluntarily confirm/ refuse amicable agreement in the trial day. The remedial law has no procedures allowing to ensure unequivocal performance of an amicable agreement without loss of time (another proceedings). Should a party fail to close a transaction, it party shall have no right to waive a claim, or to undertake to waive a claim in the future and expect for resumption of proceeding. For this reason the fact of initiated judicial contest does not allow to come to a lawful and guaranteed amicable agreement even if benefit is obvious to both parties. There are great risks of unscrupulous behaviour of one of the parties upon termination of all court proceedings, and also of possible refusal of court to approve results of amicable arrangements reached by the parties when they are already partially executed. All these factors are significantly hindering the process of loan restructuring.

The most effective method is to establish the procedure of arbitration involving intermediaries – it should be done with due advance, via cooperation of the parties aided by lawyers. In this case an independent person, whose authority is not of advisory but of binding nature, is entrusted to verify all the circumstances, and to establish procedure and amount of recovery. Regrettably, such intermediary institutes are somewhat discredited, on the one side, by imposing “dependent” intermediaries, on the other side – by lack of legal competency. However, there are several experienced arbitration agencies in St.-Petersburg, which perform well. Besides, the parties can avoid lengthy legal proceedings by creating independent arbitration institutes with due advance.

Our conclusion: there is a need to work at all stages of making and performing the contract, aimed at preventing payment default and at compelling the parties to voluntary re-structurization, rather than at running for warrant of execution and striving for judicial sale. When a creditor is quick at using legal instruments in early stages, as preventive rather than as fire fighting measures, a creditor may avoid obscure and unpromising litigations, dead debts, dead-end situations for both parties.

“Expert Severo-Zapad” no. 1-3, January 25, 2010

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